Business Cycles

Analysis on Thailand is available below. Feature Last week we were on the road meeting with some of our U.S. clients. This week’s report presents some of the key topics of our discussions in a Q&A format. Question: You have been downplaying the potentially positive impact of lower bond yields in advanced economies on EM risk assets. Why do you think lower bond yields in developed markets (DM) and potential rate cuts by DM central banks won’t suffice to lift EM markets on a sustainable basis? Answer: Falling interest rates are positive for share prices when profits are growing, even at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Presently, EM and Chinese corporate earnings are shrinking rapidly (Chart I-1). This is the primary reason why we believe DM monetary easing will not help EM share prices much. Furthermore, EM exchange rates follow relative EPS cycles in local currency terms (Chart I-2). In short, EM currencies are driven by relative corporate profitability between EM and the U.S. – not by interest rate differentials. Chart I-1EM & China EPS Are Contracting EM & China EPS Are Contracting EM & China EPS Are Contracting Chart I-2Relative EPS And Exchange Rate Relative EPS And Exchange Rate Relative EPS And Exchange Rate   The contraction in EM and China EPS has not been caused by higher interest rates and slump in DM domestic demand. Rather, the EM/China profit contraction has been due to China’s economic slowdown spilling over to the rest of EM. Crucially, there is no empirical evidence that interest rate cuts and QEs in DM preclude EM selloffs when EM/Chinese growth is slumping. Specifically: Chart I-3A and I-3B illustrate that neither the level of G4 central banks’ assets nor their annual rate of change correlates with EM share prices or EM local bonds’ total returns in U.S. dollar terms. Hence, QEs have not always guaranteed positive returns for EM financial markets. Chart I-3APace Of QE And EM Performance Pace Of QE And EM Performance Pace Of QE And EM Performance Chart I-3BPace Of QE And EM Performance Pace Of QE And EM Performance Pace Of QE And EM Performance Chart I-4U.S. Treasury Yields And EM Performance U.S. Treasury Yields And EM Performance U.S. Treasury Yields And EM Performance Chart I-4 demonstrates the correlation between U.S. 5-year Treasurys yields on the one hand and EM spot exchange rates, EM sovereign credit spreads and EM share prices on the other. There has been no stable relationship – at times it has been positive, and at other times negative. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. Even though DM monetary policy has not been the driving force of cyclical fluctuations in EM financial markets, it has had a structural impact. QEs and lower bond yields in DM have prompted an expanded search for yield and have produced substantial compression in risk premia worldwide. For example, Chart I-5 demonstrates that excess returns on EM corporate bonds have historically been correlated with the global manufacturing cycle, but the correlation has diminished in recent years. The widening gap between the two lines is due to investors’ search for yield. Investors have bought and continue to hold securities of “zombie” companies and countries that have low productivity and poor fundamentals. In short, QEs have undermined the efficiency of global capital allocation. This is marginally adverse for productivity in the global economy in the long run. Question: But doesn’t DM monetary policy influence DM demand, which in turn affects EM corporate profits? Answer: DM monetary policy influences DM domestic demand, but there is little correlation between DM domestic demand and EM corporate profits. For example, U.S. import volumes have been growing at a decent pace, yet EM corporate profits have shrunk (Chart I-6). Indeed, robust growth in U.S. imports did not preclude EM EPS contraction in 2012, 2014-‘15 and 2018-‘19, as shown in this chart. Chart I-5Fundamentals Have Become Less Important Due To QE Programs Fundamentals Have Become Less Important Due To QE Programs Fundamentals Have Become Less Important Due To QE Programs Chart I-6EM EPS And U.S. Imports EM EPS And U.S. Imports EM EPS And U.S. Imports   Chart I-7 reveals additional evidence of the diminished impact of U.S. growth on Asian exports. Korean, Taiwanese, Japanese and Singaporean exports to the U.S. are growing at 7% rate, while their shipments to China are contracting at an 11% rate from a year ago as of May. As a result, these countries’ overall exports are shrinking because they ship to China considerably more than they do to the U.S. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. The deceleration in global trade can be tracked to Chinese imports contraction (Chart I-8). Chart I-7Asia's Exports To China And U.S. Asia's Exports To China And U.S. Asia's Exports To China And U.S. Chart I-8Chinese Imports And Global Trade Chinese Imports And Global Trade Chinese Imports And Global Trade   U.S. manufacturing is the least exposed to China, which is the main reason why it was the last shoe to drop in the global manufacturing recession. Question: So, what drives EM business cycles if it is not DM growth and DM interest rates? Chart I-9China's Credit & Fiscal Impulse And EM EPS China's Credit & Fiscal Impulse And EM EPS China's Credit & Fiscal Impulse And EM EPS Answer: The key and dominant driver of EM risk assets – stocks, credit markets and currencies – has been the global trade and EM/China growth cycles. There is a much stronger correlation between EM financial markets and the global business cycle in general, and Chinese imports in particular than with DM interest rates. In turn, Chinese imports are driven by its capital spending cycle. 85% of the mainland’s good imports are composed of industrial goods and devices, machinery, chemicals, various commodities and autos. Only 15% are non-auto consumer goods. Meanwhile, the credit/money cycles drive capital spending. That is why China’s credit and fiscal spending impulse leads EM corporate profits (Chart I-9). This is also why we spend a significant amount of time analyzing and discussing China's credit cycle. Question: Why has the policy stimulus in China not revived growth in its economy and its suppliers around the world? Answer: Our aggregate credit and fiscal spending impulse bottomed in January of this year, but its recovery has so far been timid. In the past, this indicator led China’s business cycle and the global manufacturing PMI by an average of about nine months (Chart I-10, top panel) and EM corporate profits by 12 months (Chart I-9). According to this pattern, the bottom in global manufacturing should occur in August of this year. However, global share prices have not led global manufacturing PMI during this decade; they have instead been coincident (Chart I-10, bottom panel). Hence, there was no historical justification for global share prices to rally since early January - well ahead of a potential bottom in the global manufacturing PMI in August. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. That said, due to the U.S.-China confrontation and other structural reasons currently prevailing in China – including high levels of indebtedness and more regulatory scrutiny over shadow banking as well as local government debt – a recovery in mainland household and corporate spending is likely to be delayed. Crucially, as we have documented in previous reports, the marginal propensity to spend for consumers and companies continues to fall (Chart I-11). This is the opposite of what occurred in early 2016. Chart I-10Chinese Stimulus, Global Manufacturing And Global Stocks Chinese Stimulus, Global Manufacturing And Global Stocks Chinese Stimulus, Global Manufacturing And Global Stocks Chart I-11China: What Is Different From 2016 China: What Is Different From 2016 China: What Is Different From 2016   Overall, a revival in China’s growth will likely take longer to unfold and EM risk assets will likely sell off anew before bottoming. Chart I-12Global Slowdown Is Not Yet Over Global Slowdown Is Not Yet Over Global Slowdown Is Not Yet Over Chart I-13Global Semiconductor Demand Is Shrinking Global Semiconductor Demand Is Shrinking Global Semiconductor Demand Is Shrinking Question: Apart from China’s credit and fiscal spending impulse and marginal propensity to spend among households and companies, what other indicators are you monitoring to gauge a bottom in the global manufacturing cycle? Answer: Among many variables and indicators we continuously monitor, there are a few we have been paying particular attention to: The difference between global narrow (M1) and broad money growth correlates well with global corporate earnings (Chart I-12). The rationale for this indicator is that it is akin to the marginal propensity to spend: When demand deposits (M1) outpace time/savings deposits, it is indicative that households and companies are getting ready to spend on large-ticket items or kick off capital spending, and vice versa. Presently, this narrow-to-broad money growth differential continues to point to lower global growth. Last week we published a report on the global semiconductor industry, arguing that upstream demand for semiconductors is withering as sales of servers, smartphones, PCs and autos are all shrinking globally (Chart I-13). With consumption of these goods contracting, demand for semiconductors remains lackluster, and semiconductor prices are still deflating (Chart I-14). Hence, semiconductor prices can be used as an indicator of final demand dynamics in many important segments of the global economy. China’s Container Freight Index – the price to ship containers – is also currently lackluster, reflecting weak global trade dynamics (Chart I-15, top panel). Chart I-14Semiconductor Prices Are Still Deflating Semiconductor Prices Are Still Deflating Semiconductor Prices Are Still Deflating Chart I-15Global Shipments Are Very Weak Global Shipments Are Very Weak Global Shipments Are Very Weak Global Shipments Are Very Weak Global Shipments Are Very Weak   In the U.S., both total intermodal carloads and railroad carloads excluding petroleum and coal are tanking, reflecting subsiding growth (Chart I-15, middle and bottom panel). In turn, Chinese imports continue to contract. This is the primary channel in terms of how the Middle Kingdom affects the rest of the world economy. From the rest of the world’s perspective, China is in recession because their shipments to the mainland are shrinking. In China and Taiwan, the seasonally adjusted manufacturing PMI new orders have rolled over after the temporary pick up early this year (Chart I-16). Finally, we are monitoring our Reflation Indicator and Risk-On/Safe-Haven Currency Ratio (Chart I-17). Both are market-based indicators and are very sensitive to global growth conditions – especially to the dynamics in commodities markets – making them very pertinent to EM investors. Chart I-16Manufacturing PMI: New Orders Seasonally-Adjusted Manufacturing PMI: New Orders Seasonally-Adjusted Manufacturing PMI: New Orders Seasonally-Adjusted Chart I-17Market-Based Indicators Market-Based Indicators Market-Based Indicators   As with any marked price-based signals, both are very volatile. Even though both indicators have rebounded in recent days, only a major trend reversal matters for macro investors. Technically speaking, the profile of both indicators is consistent with a breakdown rather than a breakout. Question: You have highlighted that EM corporate EPS is contracting. How widespread is the profit contraction, and how long will it persist? Answer: EM corporate EPS contraction is widespread across almost all sectors. Chart I-18A and I-18B illustrate EPS growth in U.S. dollar terms for all sectors. EPS growth is negative for most sectors, close to zero for three (technology, financials and materials) and still positive for the energy sector. However, technology, materials and energy EPS are heading into contraction, given the drop in semiconductor, industrial metals and oil prices, respectively. Chart I-18ASynchronized EM EPS Contraction Synchronized EM EPS Contraction Synchronized EM EPS Contraction Chart I-18BSynchronized EM EPS Contraction Synchronized EM EPS Contraction Synchronized EM EPS Contraction   Consequently, all EM equity sectors will soon be experiencing synchronized profit contraction. EM corporate EPS contraction is widespread across almost all sectors. Our credit and fiscal spending impulse for China leads EM EPS growth by about 12 months, and it currently entails that the profit contraction will continue to deepen all the way through December (Chart I-9 on page 6). It would be surprising if EM share prices stage a major rally amid a hastening decline in corporate EPS (please refer to Chart I-1 on page 1). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Thailand: A Defensive Play Within EM The Thai parliament has elected to keep the ex-military general Prayuth Chan-ocha as the country’s prime minister. This will instill political stability for now, which is positive for investor confidence. In absolute terms, Thai financial markets are leveraged to global trade and will, therefore, sell off if our negative views on the latter and EM risk assets play out. Chart II-1Thailand's Current Account Is In Surplus Thailand's Current Account Is In Surplus Thailand's Current Account Is In Surplus Relative to their EM peers, Thai equities, credit, currency and domestic bonds will continue outperforming: The Thai current account balance remains in large surplus, which provides a large cushion for the Thai baht amid the slowdown in global growth (Chart II-1). Critically, Thailand is less exposed to China and is more leveraged to the U.S. and Europe than its EM peers. Thailand’s shipments to China account for 12% of the former’s total exports, while exports to the U.S. and EU together account for 21%. Both U.S. and European imports are holding up better than those of China. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. The country’s current FDOs stand at 8% relative to its exports of goods and services and 12% relative to the central bank’s foreign exchange reserves. The rest of EM countries have much higher ratios. In addition, foreign ownership of local currency bonds is amongst the lowest in the region (18%). As a result, currency depreciation will not trigger major portfolio outflows and a self-reinforcing downtrend in Thai financial markets. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. Chart II-2Thailand: Moderate Growth In Private Consumption Thailand: Moderate Growth In Consumption Thailand: Moderate Growth In Consumption Thailand’s private consumption is growing reasonably well (Chart II-2, top panel). Likewise, passenger and commercial vehicle sales are rising and so is household credit (Chart II-2, bottom two panels). The Thailand MSCI index carries a large weight in domestic and defensive stocks such as transportation, utilities, telecommunication, and consumer staples. These sectors will benefit from moderate consumption growth. In fact, Thai equity outperformance versus EM has been justified by its non-financial companies’ EBITDA outpacing that of EM non-financials (Chart II-3). This trend remains intact. Concerning banks, Thailand’s commercial banks suffer from credit excesses, as do many of their EM peers. However, Thai commercial banks have been responsible in terms of recognizing NPLs and have been properly provisioning for them (Chart II-4). This is contrary to many other EM banks. This means that share prices of Thai commercial banks will outperform their EM counterparts. Finally, although the Thai bourse is more expensive than its EM counterparts, relative equity valuation will likely get even more stretched before a major reversal occurs. Given our cautious view on overall EM, we continue to prefer this richly valued and defensive bourse to the more cyclical, albeit cheaper, but fundamentally vulnerable EM peers. Chart II-3Equity Outperformance Has Been Justified By Earnings Equity Outperformance Has Been Justified By Earnings Equity Outperformance Has Been Justified By Earnings Chart II-4Thai Commercial Banks Are Well Provisioned Thai Commercial Banks Are Well Provisioned Thai Commercial Banks Are Well Provisioned Bottom Line: Investors should keep an overweight position in Thai equities, currency, domestic bonds and credit markets. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy The risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P tech hardware storage & peripherals (THS&P) index. Our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Recent Changes Downgrade the S&P THS&P index to neutral, today. Put the S&P tech sector on downgrade alert. Table 1 A Recession Thought Experiment A Recession Thought Experiment Feature The SPX appeared to crack early in the week, but dovish Fed President statements saved the day and stocks recovered smartly to end the week on a high note. Our tactically (0-3 month) cautious equity market stance has served us well and has run its course. We are currently leaning toward a cyclically (3-12 month) cautious stance as a slew of our cyclical indicators have rolled over decisively. At the current juncture the big call to make is on the longevity of the business cycle. Crudely put, can the Fed engineer a soft landing or is the looming easing cycle a precursor of recession (Chart 1)? We side with the latter. Chart 1What’s The Opposite Of Bond Vigilantes? What’s The Opposite Of Bond Vigilantes? What’s The Opposite Of Bond Vigilantes? This is U.S. Equity Strategy service’s view. BCA’s house view remains constructive on a cyclical 3-12 month time horizon. As a reminder, the ongoing expansion is officially the longest on record and BCA’s house view also calls for recession in late-2020/early-2021. Stan Druckenmiller once famously said “…you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today." Thus, if BCA’s recession view is accurate then we need to start preparing the portfolio for a recessionary outcome. This week we conduct a simple thought experiment on where and why the SPX will be headed as the economy flirts with recession. But first, we rely on the message from our indicators to guide us in determining if the cycle is nearing an end. Last December parts of the yield curve slope inverted (Chart 2) and our simple insight was that the market almost always peaks following the yield curve inversion and we remained bullish on the prospects of the broad equity market and called for fresh all-time highs based on the results of our research.1 On May 1, 2019 we got confirmation as the SPX vaulted to new all-time highs, so that box is now checked. Chart 2The Yield Curve... The Yield Curve... The Yield Curve... Beyond the traditional yield curve inversion that forecasts that the Fed’s next move will be a cut and eventually the cycle ends, other yield curve type indicators have inverted and also foreshadow the end of the business cycle. Charts 3A & 3B show that the unemployment gap and another labor market yield curve type indicator have both inverted signaling that the business cycle is long in the tooth. Chart 3A...Is Always Right... ...Is Always Right... ...Is Always Right... Chart 3B...In Predicting Fed Cuts ...In Predicting Fed Cuts ...In Predicting Fed Cuts This time is no different and the business cycle will end. Why? Because the Fed has likely raised interest rates (as we first posited on November 19, 2018 and again on December 3, 2018) by enough to trigger a default cycle in the most indebted segment of the U.S. economy where the excesses are most prominent in the current expansion: the non-financial business sector (Chart 4A). Chart 4AMind The Corporate Debt Excesses Mind The Corporate Debt Excesses Mind The Corporate Debt Excesses Chart 4BDefault Cycle Looming Default Cycle Looming Default Cycle Looming Already, junk bond market spreads are widening and the yield curve is predicting that a default cycle is around the corner (yield curve shown on inverted scale, bottom panel, Chart 4B).  Another interesting indicator is the Presidential cycle. Chart 5 updates our work from last year showing years 2 & 3 of 17 Presidential cycles dating back to 1950. In the summer of year 3 the SPX typically peaks. Finally, the anecdote of the biggest unicorn, UBER, ipoing on May 10, 2019 also likely marks the ending of the cycle. Therefore if recession looms in the coming 18 months what is the typical magnitude of the SPX EPS drawdown and what multiple do investors pay for trough earnings? Chart 5Presidential Cycle Says Sell Presidential Cycle Says Sell Presidential Cycle Says Sell While the two most recent recessionary earnings contractions have been severe, we are conservative in estimating a garden variety recession causing a 20% EPS fall. S&P 500 2018 EPS ended near $162/share. This year $167/share is likely and we are now revising down our forecast for next year to $175/share from $181/share previously. A conservative 20% drawdown sets us back to $140/share in 2021. Dating back to the late 1970s when our IBES dataset on the forward P/E multiple commences, the trough forward P/E multiple during recessions averages out to 10x (Chart 6). Remaining on a conservative path we will use 13.5x, or the recent December 2018 trough multiple as our worst case multiple and a sideways move to 16.5x as the most optimistic case. This implies an SPX ending value of between 1890 and 2310 will be reached some time in 2020, with the former resetting the equity market back near the 2016 BREXIT lows. Chart 6Trough Recession Multiple Averages 10x Trough Recession Multiple Averages 10x Trough Recession Multiple Averages 10x As a result, we are not willing to play a 100-200 point advance for a potential 1000 point drawdown, the risk/reward tradeoff is to the downside. Can and has the Fed previously engineered soft landings that have caused big relief rallies in the equity market? Six times since the 1960s: once in each of the mid-1960s, early-1970s, mid-1970s, mid-1980s and mid-1990s and once in 1998 (top panel, Chart 7). Chart 7Six Mid-cycle Easing Attempts Six Mid-cycle Easing Attempts Six Mid-cycle Easing Attempts Three easing cycles were not forecast by a yield curve inversion, but the mid-1960s, the mid-1990s and in 1998 the yield curve cautioned investors that an easing cycle was looming (bottom panel, Chart 7). Specifically in 1998 the Fed only acted after the equity market fell by 20%. Another interesting observation is that ex-post five of these six iterations were truly mid cycle, one was very late cycle, but none took place in year 11 of an expansion as is currently the case. We are in uncharted territory. Chart 8 shows the mean profile of the S&P 500 six months prior to and one year post the initial Fed cut. Our assumption is that a cut in July may materialize, thus the vertical line in Chart 8 denotes t=0, which is in sync with the bond market that is pricing a greater than 75% chance of this occurrence. The subsequent market rallies were significant. Our insight from this research is that we already had the explosive rally as Chart 8 depicts, owing to the Fed’s completed pivot, with the stock market rallying from the 2018 Christmas Eve lows to the May 1, 2019 all-time highs by 26%. But, the jury is still out. The biggest risk to our call is indeed a continued rally in the S&P 500 on easy money. A way to mitigate this risk of missing out on a rally is by going long SPX LEAPS Calls once a greater than 10% correction takes root. Chart 8Is The Rally Already Behind Us? Is The Rally Already Behind Us? Is The Rally Already Behind Us? Keep in mind, that for the Fed to act and cut rates, stocks will likely have to breach the 2650 level, a point where a reflexive fall will further shake investor’s confidence in profit growth. In other words, the bond market is screaming that Fed cuts are looming, but it also means that stocks have ample room to fall before the Fed cuts rates, i.e. a riot point will force the Fed’s hand. Another big risk to this call is a swift positive resolution on the U.S./China trade dispute, and/or an unprecedented easing from the Chinese authorities which will put us offside as a euphoric rise will definitely ensue. Again SPX LEAPS Calls are an excellent way to position for such an outcome. Netting it all out, the risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the SPX hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. Thus, this week we are further de-risking the portfolio by downgrading a tech subindex to neutral, setting a tighter stop on a different long term tech subsector holding that has been the cornerstone of the equity bull market, and putting the overall tech sector on downgrade watch. Downgrade Tech Hardware Storage & Peripherals To Neutral In the context of further de-risking the portfolio we are downgrading the S&P tech hardware storage & peripherals index to a benchmark allocation and booking a small loss of 1.0% in relative terms since inception. Four reasons underpin our downgrade of this index that comprises almost 1/5 of the S&P tech market cap. First, index heavyweight Apple has 20% foreign sales exposure to the Greater China region. While we doubt the Chinese will directly retaliate to the U.S. restriction on Huawei by directly targeting Apple, it is still a risk. Moreover, recent news of the FTC and the DOJ targeting GOOGL and FB pose a risk to Apple, especially given its App Store dominance. Any negative news on either front would take a bite out of the sector’s profits. Second, capex has taken a bit hit. Chart 9 shows industry investment is almost nil and capex intentions from regional Fed surveys and from CEO confidence surveys signal more pain down the line. Third, the S&P THS&P index’s internationally sourced revenues are near the 60% mark, and computer exports are also flirting with the zero line. Worryingly, deflating EM Asian currencies are sapping consumer purchasing power and are weighing on industry exports (third panel, Chart 10). Chart 9Capex Blues Capex Blues Capex Blues Chart 10Exports... Exports... Exports... Similarly, global trade volumes have sunk into contractionary territory and to a level last seen during the Great Recession (not shown). With regard to export expectations the recently updated IFO World Economic Survey still points toward sustained global export ails (second panel, Chart 10). More specifically, tech laden Korean and Taiwanese exports are outright contracting at an accelerating pace and so are Chinese exports. Tack on the negative signal from the respective EM Asian stock market indices and the implication is that more profit pain looms for the S&P THS&P index (Chart 11). Finally, on the domestic front, new orders-to-inventories (NOI) have not only ground to a halt from the overall manufacturing sector, but also computer and electronic product NOI are not contracting on a short-term rate of change basis (bottom panel, Chart 10). Tracking domestic consumer outlays on computer and peripheral equipment reveals that they too have steeply decelerated from the cyclical peak reached in early 2018, painting a softening picture for industry sales growth prospects (Chart 12). Chart 11...Under Pressure ...Under Pressure ...Under Pressure Chart 12Soft Sales Backdrop Soft Sales Backdrop Soft Sales Backdrop  The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Nevertheless, before getting too bearish there is a silver lining. This index has a net debt/EBITDA of 0.5x versus the non-financial broad market of 2x. On the valuation front this tech subindex trades at 28% discount to the non-financial broad market on an EV/EBITDA basis suggesting that most of bad news is already reflected in bombed out valuations (Chart 13). The re-escalation of the U.S./China trade tussle along with the risk of an antitrust investigation into Apple, waning capital outlays, softening exports and deteriorating operating conditions warn that it does not pay to be overweight the S&P THS&P index. Bottom Line: Downgrade the S&P THS&P index to neutral for a modest relative loss of 1.0% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CMPE – AAPL, HPQ, HPE, NTAP, STX, WDC, XRX. Chart 13But B/S Remains Pristine But B/S Remains Pristine But B/S Remains Pristine Put Tech On Downgrade Alert We are compelled to put the S&P tech sector on our downgrade watch list as President Trump’s hawkish trade talk and actions since May 5 warn that tech revenues (60% export exposure) and profits will likely remain under intense downward pressure. The way we will execute this tech sector downgrade to underweight will be via the S&P software index, the sector’s largest market cap weight. A downgrade to neutral in the S&P software index would push our S&P tech sector weight to a below benchmark allocation. Thus, we are initiating a stop near the 10% relative return mark on the S&P software high-conviction overweight call since the December 3, 2018 inception and also lift the stop to 27% from 17% relative return on the cyclical overweight we have on the S&P software index since the November 27, 2017 inception. Any near term stock market pullback will likely trigger these stops and push the tech sector to an underweight position. Stay tuned. With regard to the overall tech sector, our EPS model is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel, Chart 14). In more detail, tech capex has recaptured market share swinging from below 6% to above 13% in the past decade and now has likely hit a wall similar to the late 1990s peak (second panel, Chart 15). On a rate of change basis tech capital outlays have all peaked and national data corroborate the message from stock market reported data (bottom panel, Chart 15). Chart 14Grim EPS Model Signal Grim EPS Model Signal Grim EPS Model Signal Chart 15Exhausted Capex? Exhausted Capex? Exhausted Capex? The San Francisco Fed’s Tech Pulse Index (comprising coincident indicators of activity in the U.S. information technology sector) is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel, Chart 14). Delving deeper into operating metrics, we encounter some profit margin trouble for tech stocks. Not only do industry selling prices continue to deflate, but also our tech sector wage bill gauge is picking up steam. Taken together, all-time high profit margins – double the broad market – appear unsustainable and something has to give (Chart 16). On the export relief valve front, the sector faces twin headwinds. First the trade war re-escalation suggests that an interruption/disruption of tech supply chains is a rising risk, and the firming greenback will continue to weigh on P&Ls as negative translation effects will hit Q2, Q3 and likely Q4 profits (Chart 17). Chart 16Margin Trouble Margin Trouble Margin Trouble Chart 17Rising Dollar Will Weigh On Revenues & Profits Rising Dollar Will Weigh On Revenues & Profits Rising Dollar Will Weigh On Revenues & Profits Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Nevertheless, there are two sizable offsets contrasting all the grim news. Tech stocks are effectively debt free with the net debt/EBITDA sitting on the zero line and valuations a far cry from the tech bubble era. Finally, the drop in interest rates via the 10-year yield and looming Fed cuts will underpin these growth stocks that thrive in a disinflationary backdrop (Chart 18). Netting it all out, our tech EPS model is flashing red on the back of sinking capex and an appreciating U.S. dollar, deteriorating operating metrics signal that tech margins are under attack and exports are also in a freefall, suggesting that the time is ripe to put the tech sector on downgrade alert. Bottom Line: We are compelled to put the tech sector on our downgrade watch list. We will execute the S&P tech sector downgrade to underweight when the S&P software index’s stops are triggered. This would push the S&P software index to neutral from currently overweight. Stay tuned. Chart 18But There Is An Offset: Melting Yields Help Growth Stocks But There Is An Offset: Melting Yields Help Growth Stocks But There Is An Offset: Melting Yields Help Growth Stocks   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But be warned, absent a continued decline in the bond yield and/or oil price, short-term positive impulses on the economy will fade and even turn negative later in the year. Hence in the summer months, look for opportunities to take profits in these pro-cyclical positions. U.K. economy plays can outperform once a cross-party parliamentary majority is found for a course of action that leads to an orderly Brexit (or no Brexit). Feature At the end of last year, we made a bold prediction: economies and financial markets would follow the opposite path in 2019 compared to 2018. Specifically we pointed out that “through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse… 2019 will present investors a mirror-image pattern to 2018” (Chart of the Week). Chart of the WeekWhy 2019 Is The Opposite Of 2018 Why 2019 Is The Opposite Of 2018 Why 2019 Is The Opposite Of 2018 Four months on, we are delighted to report that the mirror-image pattern is unfolding exactly as predicted. This year, stock markets are up sharply; bond markets have rallied; metal prices have made double-digit gains, growth-sensitive industrial shares are outperforming; while defensive healthcare shares are underperforming. All of these are the precise opposite of what happened in early 2018 (Chart 1-2 - Chart I-6). Chart I-2Equities: 2019 Is The Opposite Of 2018 Equities: 2019 Is The Opposite Of 2018 Equities: 2019 Is The Opposite Of 2018 Chart I-3Bonds: 2019 Is The Opposite Of 2018 Bonds: 2019 Is The Opposite Of 2018 Bonds: 2019 Is The Opposite Of 2018   Chart I-4Commodities: 2019 Is The Opposite Of 2018 Commodities: 2019 Is The Opposite Of 2018 Commodities: 2019 Is The Opposite Of 2018 Chart I-5Cyclicals: 2019 Is The Opposite Of 2018 Cyclicals: 2019 Is The Opposite Of 2018 Cyclicals: 2019 Is The Opposite Of 2018   Chart I-6Defensives: 2019 Is The Opposite Of 2018 Defensives: 2019 Is The Opposite Of 2018 Defensives: 2019 Is The Opposite Of 2018 Why 2019 Is The Opposite Of 2018 The basis for our bold prediction was twofold. We noted that China’s 6-month credit impulse “had gone vertical” (Chart I-7). Indeed, the rebound from the trough amounted to $500 billion (and still counting), equivalent to a near 1 percent shot in the arm for global GDP. Chart I-7China's 6-Month Credit Impulse Has Gone Vertical China's 6-Month Credit Impulse Has Gone Vertical China's 6-Month Credit Impulse Has Gone Vertical We also argued back then that “a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price is about to feed through into headline consumer price indexes. Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs.” “Coming at a time that central banks have professed a much greater reliance on incoming data, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Federal Reserve.” Lo and behold. China’s PMI has rebounded sharply, and the Fed has stopped hiking rates. Still, central banks’ enhanced ‘data-dependency’ carries perils. The high-profile hard data – such as CPI inflation and GDP growth prints – on which monetary policy ‘depends’ is a record of what happened in the past, sometimes the distant past. This year’s market moves are the precise opposite of what happened in early 2018. Hence, enhanced data-dependency means that central banks are now ‘driving by looking through the rear-view mirror’ rather than looking at the current terrain. In turn, monetary policy expectations are driving bond and equity market valuations. By contrast, equity market growth expectations are based on the here and now; they move in synch with economic activity in real-time, leading even the survey-based PMIs. This also solves the puzzle as to why bonds and equities can sometimes give conflicting messages. Last year, the configuration of accelerating inflation with decelerating global growth hit equities and with a lose-lose: heavy pressure on both valuations and growth expectations. Furthermore, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. Chart I-8In 2018, Higher Bond Yields Pressured Equity Valuations In 2018, Higher Bond Yields Pressured Equity Valuations In 2018, Higher Bond Yields Pressured Equity Valuations At low interest rates, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But in early 2018, as hawkish central banks pushed up 10-year global bond yield towards 2 percent, this process reversed viciously: bond prices lost their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets at a time that growth expectations were also sliding (Chart I-8).1 By contrast, the early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a ‘mirror-image’ win-win: a boost to both valuations and to growth expectations.  What Happens Next In 2019? Chart I-9Headline Inflation Will Soon Tick Up Headline Inflation Will Soon Tick Up Headline Inflation Will Soon Tick Up Understand that the all-important impulses to an economy do not come from the level of the bond yield, oil price, net exports, inventories, and so on. The impulse always comes from the change in these metrics. And as the metrics cannot decline (or rise) incessantly, impulses always fade and then reverse. The oil price has rebounded 30 percent from its recent lows. Necessarily, this means that headline inflation prints will soon stabilise or even tick up (Chart I-9). Furthermore, central banks’ abrupt pivot to dovish has already happened. It would be hard to repeat or continue such a move. As central banks react to the inevitably backward-looking hard data prints, our expectation is that bond yields will stabilise or even tick up. Will equity markets also react positively to the better economic data prints? Not necessarily. To repeat, equity markets’ growth expectations move in synch with economic activity in real-time, leading even the survey-based PMIs. Equity markets never wait for the backward-looking data prints. China plays are tracking its short-term credit impulse which has gone vertical (Chart I-10). Hence, in 2019 to date, U.K. mining stocks are already up 25 percent; the Shenzhen Composite is already up 40 percent! Chart I-10China Plays Have Already Surged China Plays Have Already Surged China Plays Have Already Surged Still, the current win-win configuration can continue for a little while longer, given that a typical upswing in short-term credit impulses lasts around eight months. But be warned, absent a continued decline in the bond yield and/or oil price, short-term impulses will fade and even turn negative later in the year. The early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a win-win. Hence, maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But our strong advice is: in the summer months, look for opportunities to take profits in all of these positions. When Will Brexit’s Groundhog Day End? We really would prefer not to talk about Brexit. It is not just that every day is Groundhog Day, every day is a shambolic Groundhog Day. Still, on a positive note this means that our investment strategy for Brexit has also remained a constant (Chart I-11). Chart I-11For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome It is not sufficient for the U.K. parliament to express what it is against (a no-deal Brexit); parliament must express what course of action it is for, leading to an orderly Brexit, or no Brexit, and that this course of action must also be acceptable to the EU27. At that point, irrespective of the exact course of action – a customs union, Common Market 2.0, or a confirmatory referendum in which ‘remain’ is an option – buy the pound, the FTSE250, and U.K. homebuilder shares. Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction. In this regard, Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction, because it finally puts national interest above party interest. To be clear, Brexit has been trapped in Groundhog Day because there is insufficient support among Conservative and DUP MPs for a relationship with the EU27 that would: Protect the cross-border supply chains which are vital to so many U.K. businesses. Avoid a hard customs border on the island of Ireland or between Ireland and Britain. Deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice; rather than a desire to strike independent trade deals, which is irrelevant for a majority of voters. The ray of light is that there is potentially a broader cross-party parliamentary majority for a course of action that would meet the above three conditions. Once it is found, U.K. economy plays can look forward to the “sunlit uplands”. Fractal Trading System* In line with the main body of this report, we continue to see evidence that the recent rally in bonds is technically extended. Accordingly, this week’s recommended trade is to short the 10-year OAT. The profit target is 1.3 percent with a symmetrical stop-loss. In other trades, short INR/PKR hit its 3 percent stop-loss and is now closed, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Short the 10-Year OAT Long SEK/NOK Short the 10-Year OAT Long SEK/NOK The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com  Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs One-Month Surge In China's And Taiwan's PMIs One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory Noise And Business Cycle Trajectory Noise And Business Cycle Trajectory   The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chinese Consumers' Propensity To Spend Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data China: No Improvement In "Hard" Data China: No Improvement In "Hard" Data   The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals China: Enterprises' Propensity To Spend And Metals China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate Contracting At A Double Digit Rate Contracting At A Double Digit Rate   China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices China's Infrastructure Investment And Base Metals Prices China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand China: The Outlook For Residential Property Demand China: The Outlook For Residential Property Demand   Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending China's Aggregate Fiscal Spending China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP.  Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. China Is Not Reliant On Exports To The U.S. China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad Global "Hard" Data Are Still Bad Global "Hard" Data Are Still Bad   Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data China: Credit Impulse Leads "Hard" Data China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks bca.ems_wr_2019_04_04_s1_c13 bca.ems_wr_2019_04_04_s1_c13 The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Commodities Markets Are Flashing Amber For EM Stocks Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market A Message From EM Corporate Credit Market A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move The U.S. Dollar Is About To Make A Big Move The U.S. Dollar Is About To Make A Big Move   The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads The Korean Won Is At Crossroads The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks A Stop-Buy On EM Stocks A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building.   Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Malaysian Stocks Relative to EM Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Property Sector Is Depressed Property Sector Is Depressed Chart II-3Consumer Sector Is Weak Consumer Sector Is Weak Consumer Sector Is Weak   An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Corporate Restructuring On The Way? Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now Malaysia: 2015 Vs. Now Malaysia: 2015 Vs. Now   Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious Brazil: Public Debt Dynamics Are Precarious Brazil: Public Debt Dynamics Are Precarious     In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The yield curve has inverted: The 10-year Treasury bond yield fell below the 3-month T-bill rate following the March FOMC meeting and has remained there since. We never say it’s different this time, but there is not yet sufficient evidence to change course: The yield curve is almost always early as a standalone signal, and the depressed term premium may make it less sensitive right now. Monetary policy still looks decidedly accommodative to us, … : Our estimate of the equilibrium fed funds rate says policy’s easy, and that it’ll stay that way until the Fed gets serious about hiking rates again. … so asset allocation should continue to favor risk assets: There are global forces restraining Treasury yields, but the fed funds rate cycle is only partway through a stretch that has been uniformly unfavorable for Treasuries. Feature Last week’s data were soft, as the U.S. economy continues to show signs of decelerating. The consumer confidence survey disappointed hopes for an extended bounce back from January’s shutdown-shadowed release, housing starts were uninspiring, and the Case-Shiller index revealed that home-price gains continue to sag. Beyond the U.S., the message from manufacturing PMIs is glum, although the services sector seems to be holding up just fine. Our traveling colleagues report that investors around the world have developed a decided aversion to European assets. We remind our clients that deceleration is nothing new. It’s been the story so far this year, as the incremental decline in fiscal thrust ensured it would be. The inversion of the yield curve is new, however, and it’s commanding attention from the financial media and from investors drawn to a leading indicator that consistently works. We like the yield curve, too, and it’s one of the three components of our recession indicator, but it’s only one. The other two components have yet to confirm its message, and the way things look now, it may well be awhile before they do. The Yield Curve Has Inverted, The Yield Curve Has Inverted The 3-month-to-10-year segment of the yield curve inverted after the March FOMC meeting, and it dipped a little further into negative territory last week as the 10-year Treasury yield continued to melt. An inverted curve is one of the three components of our simple recession indicator,1 and we believe it can send an important signal about the economy’s vigor and the state of monetary policy. By itself, however, an inverted curve is not a sufficient precondition for a recession. It has also been something less than a timely guide to asset allocation, inverting a year ahead of a recession, on average, and six months before the S&P 500 peaks (Table 1). The yield curve has been a reliable recession warning signal, but it tends to be too early to serve as a practical guide to money management and asset allocation. Table 1Inverted Yield Curves, 1968 - 2018 Keep Calm And Carry On Keep Calm And Carry On   An inverted yield curve has called eight of the seven recessions that have occurred over the last 50 years, making it a dependable leading indicator (Chart 1). Year-over-year contraction in the Conference Board’s Leading Economic Index (LEI) has compiled the same enviable track record, calling all seven of the last half-century’s recessions with just one false positive (Chart 2). LEI tends to be timelier, however, sounding the alarm an average of five months after the curve inverts (Table 2). For our recession indicator, we also add a comparison of the fed funds rate to our estimate of the equilibrium fed funds rate, because recessions have only occurred when the fed funds rate has exceeded our estimate of the equilibrium rate (Chart 3). Chart 1The Yield Curve Has Been Reliable, Albeit Early The Yield Curve Has Been Reliable, Albeit Early The Yield Curve Has Been Reliable, Albeit Early Chart 2LEI Has Been Timelier LEI Has Been Timelier LEI Has Been Timelier Table 2LEI Contractions, 1968 - 2018 Keep Calm And Carry On Keep Calm And Carry On   The cycle is extended, and the inverted curve has made us even more alert for trouble in the economy and financial markets, but we do not think trouble is imminent. The LEI is clearly decelerating, but it has yet to contract. We currently peg the equilibrium fed funds rate at about 3⅛%, and project that it will rise to 3⅜% by the end of the year. We can’t know the equilibrium rate with exact precision in real time, but our estimate has been a reliable guide to financial market performance, and the fact that the fed funds rate is four 25-basis-point hikes from crossing the line gives us some comfort that neither a recession nor a bear market is waiting just around the corner. Chart 3Recessions Only Occur When Policy Is Tight Recessions Only Occur When Policy Is Tight Recessions Only Occur When Policy Is Tight Bottom Line: We are not dismissing the inverted yield curve, but our other recession-indicator inputs are not confirming its warning. Given the Fed’s new guidance, we expect that the next recession will not arrive before mid-to-late 2020. It’s A Little Bit Anomalous This Time At its best, an inverted yield curve is a signal from the bond market that the Fed has tightened monetary policy too much, heralding future rate cuts and a sharp slowdown. Anything affecting yields at the long end, however, has the potential to skew the curve’s signal. If long yields were somehow inflated, the curve would be less prone to invert and the signal would be delayed. If long yields were restrained, the curve would be prone to invert sooner and the signal might come especially early. Rate hikes invert the curve once the bond market decides they’re unnecessary, or expects that they’re going to be reversed soon. We believe that the yield curve currently has a bias to invert even earlier than it otherwise would. The question of how much the Fed’s asset purchases have affected the term premium,2 if at all, is far from settled within either the Fed or BCA, and is beyond the scope of this report. Nonetheless, we do think that QE1, QE2, and QE3 must have made some contribution to the decline in the term premium on long-term bonds (Chart 4). The bottom line is that we think the curve was disposed to invert earlier this time around. Its signal is still worth incorporating into our analysis, but we will seek confirmation from our other recession indicators before revamping our asset-allocation recommendations in line with an approaching inflection point in the business cycle. Chart 4The Curve Inverts More Easily When The Term Premium Is Negative The Curve Inverts More Easily When The Term Premium Is Negative The Curve Inverts More Easily When The Term Premium Is Negative The Fed And The Yield Curve We subscribe to the idea that the Fed induces recessions by removing monetary accommodation in an attempt to keep the economy from overheating. It’s simply too difficult to achieve a soft landing with policy tools that influence activity indirectly and with long and variable lags, given that the dual-mandate metrics are themselves lagging indicators. Compared to the path by which the Fed influences the economy, the path by which it inverts the curve is simple and straightforward. It raises short rates, and the long end rises as well, as the bond market discounts higher inflation and/or stronger growth, until investors no longer believe that inflation or growth prospects merit tighter policy, and long rates fall behind short rates. We reviewed moves in 10-year yields and 3-month rates across the different phases of the fed funds rate cycle (Chart 5) to see how the process has unfolded empirically. As the mechanics of yield curve inversion imply – short rates rise, long rates rise less or fall – the curve bear flattens when the Fed hikes the fed funds rate, and bull steepens when it cuts it (Table 3). The outcome fits the intuition: if the Fed’s attempt to slow the economy with higher short rates is successful, real interest rates will decline, inflation pressure will ease and bond yields should fail to keep pace with bill rates, especially if investors associate tightening campaigns with recessions. Conversely, if the Fed successfully boosts the economy with lower short rates, bond yields should fall less than short rates as the real component of rates rises, and the curve should steepen. Chart 5 Table 3The Yield Curve And The Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Depicting our stylized fed funds rate as a bell curve makes for an appealing picture, but it obscures the fact that the Fed often pauses for a while after hiking rates to their cyclical peak, or cutting them to their cyclical trough. Phase II doesn’t end until the beginning of the next rate-cutting campaign, and Phase IV doesn’t end until the beginning of the next series of rate hikes. A stricter representation of the fed funds rate cycle would have two phases of active hiking, followed by a state of limbo between the last hike and the first cut, then two phases of active cutting, followed by a lull during which the Fed waits for signs that it should remove accommodation. The expanded fed funds rate cycle is therefore composed of active hiking in Phase I and Phase II(a), pre-easing in Phase II(b), active easing in Phase III and Phase IV(a), and pre-hiking in Phase IV(b). Table 4 shows the average monthly changes in the yield curve and its components in the expanded fed funds rate cycle. There is quite a difference between Phase II(a), when the curve aggressively bear flattens, and Phase II(b), when the curve modestly bull flattens. Phase IV(a) features a sharp bull steepening, while the long end drifts higher in Phase IV(b) and short rates barely budge. Ultimately, the real action happens when the Fed is actively adjusting monetary policy, and the duration positioning implications are quite sensitive to the transitions into and out of the active phases. Table 4The Yield Curve And The Expanded Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Bonds And The Fed Funds Rate Cycle An inverted yield curve has provided a reliable early-warning signal about recessions, but it can be too early to drive asset-allocation decisions for a manager judged on relative returns. The curve moves in Tables 3 and 4 offer more timely implications for duration positioning within fixed-income portfolios across the fed funds rate cycle. It comes as no surprise that Treasuries perform better when the Fed is cutting rates (Phases III and IV) than they do when the Fed is hiking them (Phases I and II). Their returns should be inversely correlated with the direction of rates, and longer-maturity instruments should exhibit greater sensitivity to changes in the fed funds rate (Table 5). Table 5Treasuries And The Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Overweight duration within bond portfolios from when the Fed stops hiking rates until it stops cutting them; underweight duration when it’s actively hiking. Expanding the fed funds rate cycle to account for active hiking, active easing, and the pre-hiking/pre-cutting limbo periods makes the duration-positioning road map clearer. Treasuries lose ground in real terms when the Fed is actively hiking, with longer-maturity instruments bearing the brunt (Table 6). They deliver in a big way when the Fed is actively easing (Phase III and Phase IV(a)), with the Barclays Bloomberg Long Treasury Index posting double-digit annualized total returns. Longer Treasuries shoot out the lights once the Fed stops hiking (Phase II (b)), and they generate real total returns that compare favorably with bull-market equities when aggregating Phase II(b)’s pre-easing results with active-easing Phases III and IV(a). Table 6Treasuries And The Expanded Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Our terminal and equilibrium fed funds rate estimates are admittedly far from the consensus. Markets are skeptical of the FOMC’s one-more-hike projection, much less our three, four, or more terminal-rate call. With “secular stagnation” searches ascendant on Google Trends (as of Friday morning, the partially complete March 24-30 period already had the most searches of any week over the last twelve months), our equilibrium estimate is also surely out of step with the herd. If the Fed is not done, however, history says it’s not yet time to overweight duration. If we’re right, Treasuries still have the full Phase II(a) ahead of them, and won’t be a buy until the Fed desists, sometime in 2020 or beyond. Investment Implications We have taken note of the inverted yield curve, but we will not overreact to it. While it has been a reliable recession indicator for the last half-century, it consistently sounds the alarm too early to merit immediate investment action. Neither the LEI nor our equilibrium fed funds rate model has yet corroborated its warning, and the bombed-out term premium may have biased it to inverting even sooner than it otherwise would. There’s no need for Paul Revere to ready his horse just yet. We did not anticipate that the 10-year Treasury yield would decline as much as it has. The extent of the Fed’s dovishness caught us off guard, and the 10-year Treasury is having a very hard time escaping the gravity of the decline in major-economy sovereign yields around the world. Our Global Fixed Income Strategy service (GFIS) points out that the global yield decline has become extended (Chart 6), and it contends that global bond prices incorporate too much pessimism about global economic momentum. The GFIS team also notes that there’s no guarantee stock prices will fall to align with bond yields – over the last couple years, stocks and bonds have recoupled following yield scares via bond, not equity, sell-offs (Chart 7). Chart 6Enough Is Enough Enough Is Enough Enough Is Enough Chart 7Equities Have Been Smarter Than Bonds The Last Few Years Equities Have Been Smarter Than Bonds The Last Few Years Equities Have Been Smarter Than Bonds The Last Few Years We therefore remain constructive on the economy and financial markets, and advise that balanced portfolios should still maintain exposure to riskier assets. Much of that view depends on Chinese authorities relaxing their deleveraging campaign, global trade tensions easing, and some hint of green shoots appearing in the rest of the world. If those elements of our base-case scenario fail to materialize, we will likely become more cautious. We are not happy that the vindication of our high-conviction view on the terminal fed funds rate has been indefinitely delayed, but the silver lining of the Fed’s dovish surprise is that the bull market in equities and other risk assets has been granted an open-ended extension.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report, “How Much Longer Can The Bull Market Last?,” published August 13, 2018. Available at usis.bcaresearch.com. 2 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument.

Highlights Driven by its fear that deflation is a more intractable danger than inflation, the Federal Reserve has enshrined its pause for the remainder of 2019 in order to lift inflation expectations. Since the U.S. business cycle expansion is not over, the Federal Reserve’s plan to put policy on hold this year raises the odds that the economy will overheat. Global growth is set to bottom during the second quarter in response to easier financial conditions. Accommodative policy, rebounding global economic activity and a softening dollar will boost risk asset prices during the remainder of the year. Safe-haven bonds, including Treasurys, will underperform cash over the coming 12 to 18 months. The rally in risk assets will ultimately prove the last hurrah as the Fed will resume tightening later this year or in 2020, and a bear market lies down the road. Only investors with tactical investment horizons should aggressively play this rally. Those with longer investment horizons should use this rally to lighten up their exposure to risk. Feature Introduction Following the introduction of the word “patience” into the Federal Reserve’s lexicon, a move lower in the so-called Fed dots was to be anticipated. The FOMC now expects no rate increases in 2019 and only one hike in 2020. The interest rate market remains skeptical that the Fed will be able to deliver on its forecast. For now, the OIS curve is pricing in a 75% probability of a cut this year, and rates at 1.9% by the end of 2020. With the 10-year/3-month yield curve inverting last week and the U.S. Leading Economic Indicator still decelerating, it is no wonder that investors are betting on the Fed becoming ever more dovish (Chart I-1). BCA is inclined to take the Fed at its word – the next move will be a hike, not a cut. This call rests on our view of the business cycle: The fed funds rate is still somewhat below neutral, U.S. economic activity can expand further, and global growth is likely to trough soon. The current dovish inclination of global central banks will only nurture the cycle a little bit longer. Consequently, we continue to recommend a positive stance on stocks for the coming quarters, while keeping in mind that the cycle is long in the tooth, and that beyond this last climb lies a significant bear market. The U.S. Business Cycle Has Further To Run… The Fed remains data dependent, but this now means that depressed inflation expectations in the private sector need to be vanquished before the hiking can resume (Chart I-2). With the view that low realized inflation has curtailed expectations now common across major central banks, this implies that a temporary overshoot in actual core PCE will be tolerated in order to lift expectations. Chart I-1Worrisome Signs For Growth Worrisome Signs For Growth Worrisome Signs For Growth Chart I-2The Fed Wants To Lift Inflation Expectations The Fed Wants To Lift Inflation Expectations The Fed Wants To Lift Inflation Expectations   Since consumer prices are a lagging variable, lifting both realized and anticipated inflation will only be possible if we move ever further along the business cycle, further pressuring the economy. Our base case remains that the risk of a recession is low in 2019, and is even receding in 2020. First, U.S. credit-dependent cyclical spending currently constitutes only 25.3% of potential GDP. As Chart I-3 illustrates, this is in line with its historical average, and well below the levels recorded near the end of previous business cycles. This suggests that the amount of vulnerability caused by misallocated capital is not yet in line with previous cycles. It also indicates that the share of output generated by the sectors most sensitive to higher rates is also low. Chart I-3U.S. Cyclical Spending: Limited Signs Of Vulnerability U.S. Cyclical Spending: Limited Signs Of Vulnerability U.S. Cyclical Spending: Limited Signs Of Vulnerability Second, the consumer remains in good shape. Households have deleveraged, and debt-service payments relative to disposable income are still near multi-generational lows (Chart I-4). Moreover, thanks to a saving rate of 7.6%, consumer spending is likely to move in line or even outperform income growth. On this front, the outlook is also good. As Chart I-5 demonstrates, the link between wages and salaries relative to the employment-to-population ratio for prime-age workers – a measure of labor utilization unaffected by the demographic changes that have muddied the interpretation of the unemployment rate – is still as tight as it was 20 years ago. Thus, as long as the labor market does not suddenly collapse, wage growth will continue to accelerate, supporting household income and consumption.   Chart I-4Household Balance Sheets Are Solid Household Balance Sheets Are Solid Household Balance Sheets Are Solid Chart I-5 Third, at 0.4% of GDP, the fiscal thrust remains positive. In other words, fiscal policy will still add to GDP in 2019. Fourth, we do not see the traditional symptoms associated with a fed funds rate above neutral. After dipping sharply in the second half of 2018, mortgage for purchase applications are back near their cycle highs (Chart I-6). Moreover, the performance of homebuilders’ equities relative to the broad market has begun to rebound, which is inconsistent with a fed funds rate above neutral. Chart I-6Mortgage Applications Do Not Suggest Policy Is Tight Mortgage Applications Do Not Suggest Policy Is Tight Mortgage Applications Do Not Suggest Policy Is Tight Fifth, there is scope for the contribution from housing sector activity to morph from a negative to a positive. A fed funds rate below neutral historically is correlated with an improving housing market. Rising mortgage rates from 3.8% to 4.6% depressed home sales and construction output, and the fall in mortgage rates over the past x month 4.3% should stimulate housing activity (Chart I-7). Chart I-7Residential Activity Will Rebound This Year Residential Activity Will Rebound This Year Residential Activity Will Rebound This Year Bottom Line: U.S. first-quarter GDP growth will be dismal, but one quarter does not make a trend. The low degree of economic vulnerability in the U.S., and the likelihood that the fed funds rate will stay below neutral for a while suggest that growth should rebound to the 2-2.5% range and should remain above-trend for the remainder of 2019. … And Global Growth Will Soon Trough As the cliché goes, it is darkest before the dawn. This is a fitting description of the world economy outside the U.S. right now. Global trade is depressed, global PMIs are moribund and nothing feels good. But it is exactly when nothing is going well that one needs to wonder what may cause the outlook to turn for the better. Thankfully, green shoots are emerging. To begin with, central banks around the world have taken a more dovish slant. This dovish forward guidance is nurturing global activity via a significant easing in global financial conditions, which is undoing the severe brake-pumping imposed on global growth in the fourth quarter of 2018 (Chart I-8). Chart I-8Global Financial Conditions Are Easing Global Financial Conditions Are Easing Global Financial Conditions Are Easing This more dovish forward guidance has helped our Financial Liquidity Index, which sharply deteriorated through 2009, rebound. Historically, this presages an improvement in the BCA Global Leading Economic Indicator (Chart I-9). Improving liquidity conditions have already been reflected in lower real rates around the globe, creating a reflationary impulse. EM financial conditions are responding positively, pointing to an upcoming pick-up in industrial activity, as measured by our Global Nowcast (Chart I-10). Chart I-9Improving Global Liquidity Backdrop Improving Global Liquidity Backdrop Improving Global Liquidity Backdrop Chart I-10A Tailwind From EM? A Tailwind From EM? A Tailwind From EM? Our Global LEI diffusion Index has begun to reflect some of these developments. After forming a trough in 2018, more than 50% of the countries in our Global LEI are currently experiencing a sequential improvement in their LEIs. We are now entering the normal lag after which a broadening growth impulse converts into aggregate activity moving higher (Chart I-11). Most interestingly, investors do not seem to be anticipating such a rebound. There is therefore room for growth surprises around the world. Chart I-11Scope For Growth Surprises Scope For Growth Surprises Scope For Growth Surprises China has a role to play in this story, will likely morph from a headwind to global growth to a positive. Positive may be a strong word, but at the very least, we expect China to stop detracting from global growth. Premier Li-Keqiang recently put the accent on stability and preserving employment, suggesting Chinese policymakers are likely to de-emphasize deleveraging over the coming 12-18 months. For Chinese growth to improve, deleveraging does not even have to stop. As both theory and history have shown, a slower pace of deleveraging means that the credit impulse moves back into positive territory and growth re-accelerates, even if only temporarily (Chart I-12). Chart I-12Growth Can Improve Even If Deleveraging Continues Growth Can Improve Even If Deleveraging Continues Growth Can Improve Even If Deleveraging Continues As a thought experiment, if Chinese leverage were to stabilize this year and nominal growth were to hit 8% – the lower bound of the real GDP target of 6-6.5% and inflation of 2% – the Chinese credit impulse would surge to more than 10% of GDP (Chart I-13)! We are not forecasting such a large rebound in the impulse, but this exercise clearly shows that if the Chinese authorities – who are cutting taxes and trying to ease credit conditions for small- and medium-sized enterprises – want to favor stability and employment for just one year, the impact on growth will be non-negligible, even if deleveraging continues. Since domestic demand responds to the credit impulse, and imports sport an elevated beta to domestic demand, Chinese imports are likely to soon morph from a negative to something more neutral – maybe even a small positive for the rest of the world. Chart I-13A Thought Experiment A Thought Experiment A Thought Experiment Finally, as weak as Europe is right now, it will likely be an important source of positive surprises in the second half of the year. To begin with, Europe is much more sensitive to EM growth conditions than the U.S. (Chart I-14). In the same way as Europe felt the full force of the deceleration in global trade last year, it will benefit from any improvement in trade this year. Chart I-14 A myriad of idiosyncratic shocks rammed through the euro area last year, worsening an already difficult situation. The new WLTP emission standards caused German auto production to collapse by nearly 20%. Nonetheless, as contracting domestic manufacturing orders and a large inventory pullback in the final quarter of last year suggest, the inventory overhang has been worked off (Chart I-15, top panel). Chart I-15Passing European Idiosyncratic Shocks Passing European Idiosyncratic Shocks Passing European Idiosyncratic Shocks Just as critically, Italy’s technical recession should end soon. The country’s economic malaise reflected the tightening in financial conditions that followed the violent battle between Rome and Brussels early last year. Ultimately, Rome folded: The budget deficit is 2.3% of GDP, not above 6%, and threats of leaving the union have been abandoned. Consequently, financial conditions are easing. Italian bond auctions are massively oversubscribed this year, and rising bond prices are supporting the solvency of the Italian banking system. The last hurdle affecting Europe was the fact that funding stress in the Italian and Spanish banking systems have been directly addressed by the TLTRO-III announced three weeks ago by the European Central Bank. Spanish and Italian banks have to refinance EUR 425 billion of TLTRO-II this June, in a year where a sizeable amounts of European bank bonds also needs to be refinanced. This is simply too much. With the ECB again bankrolling Italian and Spanish financial institutions, funding stress in the periphery can decline. Consequently, the European credit impulse, which had formed a valley in 2018 Q1, can continue its ascent (Chart I-15, bottom panel). Bottom Line: Investors expect little from the global economy outside the U.S., yet easing liquidity and financial conditions, a temporary shift in Chinese policy preferences and passing idiosyncratic shocks in Europe all point to improvement in global economic activity. U.S. Inflation Expectations Will Allow The Fed To Resume Rate Hikes Above-potential growth in the U.S. and rebounding economic activity in the rest of the world are consistent with higher – not lower – U.S. inflation. First, rebounding global growth is normally associated with a weakening dollar (Chart I-16). This time will not be different, especially as U.S. equity valuations relative to global stocks suggest that investors are particularly pessimistic on non-U.S. growth. A weaker dollar will lift import prices, commodity prices, and goods prices, helping inflation move higher. Chart I-16The USD Is Counter-Cyclical The USD Is Counter-Cyclical The USD Is Counter-Cyclical Second, the change in the velocity of the money of zero maturity in the U.S. is consistent with a further strengthening in core inflation (Chart I-17). Chart I-17The Fisher Equations Points To Gently Rising Inflation The Fisher Equations Points To Gently Rising Inflation The Fisher Equations Points To Gently Rising Inflation Third, above-trend U.S. growth in the context of elevated capacity utilization is also consistent with rising inflation (Chart I-18). Chart I-18Elevated U.S. Capacity Utilization Elevated U.S. Capacity Utilization Elevated U.S. Capacity Utilization If these three forces can cause core PCE inflation to move slightly above 2% in the second half of 2019, this will likely result in inflation expectations firming. Moreover, the combination of positive growth surprises around the world and easy monetary and liquidity conditions will prove supportive of asset prices globally, implying further easing in global and U.S. financial conditions. This set of circumstances will allow the Fed to shift its tone toward the end of 2019, in order to crystalize additional hikes in 2020. Additionally, we estimate the U.S. terminal policy rate to be around 3.25%. In fact, a longer-than-originally-anticipated Fed pause reinforces confidence in this assessment, even if it means that it will take longer to reach the terminal level than we previously thought. Bottom Line: Our growth outlook is consistent with robust inflation and improving inflation expectations. This means we disagree with interest rate markets and anticipate the Fed will resume its hiking campaign instead of cutting rates next year. Moreover, easier-for-longer policy also strengthens our view that the fed funds rate can end this cycle near 3.25%. Stay Positive On Risk Assets For Now… Most bear markets are linked to recessions. It follows that if the U.S. business cycle can be extended and the Fed remains on the easy side of neutral for longer, then the S&P 500 has more upside (Chart I-19). So do global equities. Chart I-19Low Bear-Market Risk Low Bear-Market Risk Low Bear-Market Risk This view is reinforced by the fact that buy-side analysts and investors alike have aggressively curtailed their expectations for EPS growth this year, to 3.9% for the U.S. and 4.9% outside the U.S. Yet, our profit model suggests that U.S. EPS growth is likely to come in at around 8.1% this year. Earnings revisions are pro-cyclical. Hence, our expectation that the BCA global Leading Economic Indicator meaningfully revives in the second half of 2019 points toward analysts having ample room to revise global earnings higher in the second half of the year (Chart I-20). Chart I-20Global Profit Margins Will Improve If Growth Rebounds Global Profit Margins Will Improve If Growth Rebounds Global Profit Margins Will Improve If Growth Rebounds Moreover, global valuations experienced a reset last year. Despite a rebound, the forward P/E ratio for the MSCI All-Country World Index remains in line with 2014 levels, 12.5% lower than at their apex last year. When looking at the U.S., our composite valuation index has also improved meaningfully (Chart I-21). This improvement in valuations increases the probability that a bottom in global growth will lift stock prices. Chart I-21Large Improvement In The Equity / Risk Reward Ratio Large Improvement In The Equity / Risk Reward Ratio Large Improvement In The Equity / Risk Reward Ratio Our Monetary Indicator further reinforces this message. After being a headwind for stocks over the past eight quarters, now that the Fed has paused and is essentially guaranteeing low real rates for an extended period, this gauge is growing more supportive of further equity price gains (Chart I-22). Chart I-22Stock-Friendly Monetary Backdrop Stock-Friendly Monetary Backdrop Stock-Friendly Monetary Backdrop A below-benchmark duration exposure for fixed-income portfolio still makes sense, even if the Fed has prolonged its pause. As per our U.S. Bond Strategy service’s “Golden Rule Of Treasury Investing,” if the Fed increases rates more than the market has priced in 12 months prior, Treasurys underperform cash (Chart I-23). Even if the Fed does nothing this year, it will still be more than the OIS curve is currently pricing in. Moreover, the dollar is likely to soften and the Fed is increasingly taking the risk of falling behind the realized inflation curve. This should create upside not only for inflation breakevens but also for term premia, which are depressed everywhere across the G-10. The yield curve should modestly steepen in this environment. It may take a bit more time than we originally expected, but safe-haven bond yields are trending higher, not lower. Chart I-23The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing Spread products are also likely to continue to do well. Easy monetary policy, a soft U.S. dollar, an ongoing U.S. business expansion, an upcoming rebound in global growth and rising asset values all point toward a delay of the inevitable wave of defaults. Corporate bonds may offer poor value and credit quality has deteriorated, but an end to the business cycle and a tighter Fed will be key to catalyzing these poor fundamentals. We are not there yet. The Brexit saga continues to have the potential to unsettle markets. Nonetheless, we would fade any broad market sell-off linked to poor British headlines. As Marko Papic writes in this month's Special Report, despite continued political uncertainty in Westminster this year, the risk of a no-deal Brexit is dwindling by the minute, and political logic suggests that there is a high probability that the U.K. will ultimately remain in the EU in two to three years. Bottom Line: After the reset in valuations and earning expectations last year, markets should continue their ascent. The Fed has showed that its “put” is alive and well. This will both favor risk-taking and extend the duration of the business cycle. If global growth can rebound in the second quarter, it will create fertile ground for strong asset prices over the bulk of 2019. Treasury yields will also exhibit upside, even if achieving these higher rates will take more time now. … But Beware What Lurks Below The benign outlook for this year masks that the rally in risk assets is living on borrowed time. A Fed willingly falling behind the curve may fan speculative flames this year, but it doesn’t mean that policy will stay easy forever. On the contrary, the inevitable rise in inflation will push rates higher down the road and the unavoidable recession will ultimately materialize, most likely somewhere around 2021. Since asset valuations will only grow more inflated between now and then, a bigger fall will ultimately ensue. Our Composite Valuation Indicator may currently be flashing a positive signal, but dynamics within its components already point to brewing trouble down the road (Chart I-24). First, the balance sheet group of indicators has showed no improvement. In other words, without last year’s rebound in profitability, stocks would not be as attractively valued as the overall indicator suggests. Chart I-24Disconcerting Internal Dynamics Disconcerting Internal Dynamics Disconcerting Internal Dynamics Second, the interest rate group is currently flattering aggregate valuations. To remain supportive of higher returns ahead, this group depends on interest rates staying constrained. Here, the Fed will play a particularly perverse role. Its willingness to tolerate inflationary pressures right now means lower rates today at the price of a higher cost of capital tomorrow. Once it becomes obvious that the Fed is falling behind the curve – something more likely to happen once inflation expectations normalize – safe-haven yields will rise sharply. The interest rate group will suddenly look a lot less supportive than it does today. Third, the profit components of our valuation indicator may look healthy today, but this will not remain the case. At 31.7%, EBITD margins are currently extraordinary elevated. In fact, if the profit margins were to normalize to their historical average, the Shiller P/E would skyrocket to 40.3 from 29.9 today, implying the stock market may be just as expensive as it was at the start of 2000. For margins to remain wide, wages will have to stay depressed relative to selling prices (Chart I-25). However, the combination of an economy at full employment and the Fed goosing economic growth points to rising wages. Since the pass-through from wages to prices is below 100%, unless productivity rises more than labor costs, profitability will suffer and P/E ratios will start sending the same message as the price-to-sales ratio, a multiple that currently stands near record highs. Chart I-25Rising Wages Will Ultimately Hurt Profits Rising Wages Will Ultimately Hurt Profits Rising Wages Will Ultimately Hurt Profits Valuations are not the only danger lurking for stocks: Spread products will morph from a tailwind to a headwind for equities. Whether or not it steepens a bit this year, the yield curve’s previous big flattening already points toward rising financial market volatility (Chart I-26). The Fed’s recent dovish tilt can keep the VIX and the MOVE compressed for a while longer. However, since inflation expectations will ultimately move higher, likely within a year or so, the Fed will once again tilt to the hawkish side, and volatility will follow its path of least resistance higher. Carry trades of all kinds will suffer, and spreads will widen. The deteriorating credit quality this cycle, with BBB and lower-rated issues constituting 60.1% of the corporate universe, could make this widening more violent than normal. This phenomenon will hurt stocks. Chart I-26Volatility Is A Coiled Spring Volatility Is A Coiled Spring Volatility Is A Coiled Spring Finally, the improvement in global growth this year is likely to prove temporary. China may want to slow the pace of deleveraging this year, but pushing debt loads lower and reforming the economy remains Beijing’s number one priority on a multi-year horizon. China has created USD 26 trillion worth of yuan since 2008, making the Chinese money supply larger than the euro area’s and the U.S.’s together. As a result, China’s incremental output-to-capital ratio continues to trend lower, implying large misallocation of capital (Chart I-27). State-owned enterprises, the recipients of much of the credit created over the past 10 years, now generate lower RoAs than their cost of borrowing, an unmistakable sign of poorly allocated funds. Chart I-27The Biggest Threat To China's Long-Term Prosperity The Biggest Threat To China's Long-Term Prosperity The Biggest Threat To China's Long-Term Prosperity Correcting this structural impediment will require the Chinese credit impulse to once again move back into negative territory. This means that unless Chinese policymakers abandon their efforts to prise the country off easy credit, Chinese growth will morph back into a headwind for the world somewhere in 2020, i.e. not so late as to encourage excesses, but not so early as to sharply slow the economy ahead of the Communist Party’s one-hundredth birthday in July 2021. In 2018, the global economy nearly ground to a halt after China had shifted from stimulus to policy tightening. The next time around, we doubt that a global recession will be avoided. The second half of 2020 may set up to be one tumultuous period. Bottom Line: In all likelihood, global risk assets should perform well this year, but we are living on borrowed time. In the background, equity valuations are deteriorating meaningfully, a phenomenon that will worsen once the Fed’s desired outcome comes to fruition: higher inflation. Wage pressures and higher interest rates will reveal how fully rotten stock valuations genuinely are. Compounding this effect, higher volatility and a resumption of China’s deleveraging efforts will likely achieve the coup de grace for stocks in the second half of 2020. Conclusion The FOMC wants to lift inflation expectations in order to defuse any lingering deflationary risk. Consequently, the Fed’s pause will last longer than we originally anticipated, but terminal rates are likely to climb higher than would have otherwise been the case. Before last week’s Fed meeting, the U.S. was already set to grow above trend. Now, the Fed will only extend the business cycle further, fanning greater inflationary pressures in the process. This potentially misguided reflationary impulse, which is echoed around the world, will contribute to a rebound in global growth that will become fully evident by the summer. Consequently, we expect risk assets to climb to new highs over the coming 12 months. Treasurys will likely underperform cash over that timeframe, as interest rate markets are currently too sanguine. Investors are facing a real dilemma. On one hand, the potential for elevated stock market returns is high over the coming 12 months. On the other, poor valuations will only grow more onerous, and the Fed will ultimately have to tighten policy even more following the on-hold period. Moreover, Chinese policymakers are unlikely to ignore the pressing danger created by misallocating capital for an extended period of time. Consequently, the outlook for long-term returns is deteriorating. As a result, we recommend more tactically minded investors to stay long stocks, with a growing preference for international equities that are both cheaper and more exposed to global growth than U.S. ones. However, longer-term asset allocators should use this period of strength to progressively move out of stocks and into safer alternatives. Mathieu Savary Vice President The Bank Credit Analyst March 28, 2019 Next Report: April 25, 2019   II. The State Of Brexit So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart II-1). Chart II-1The Euro Area Stands Unified The Euro Area Stands Unified The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart II-2), the erosion of its manufacturing economy (Chart II-3), and the ballooning of the country’s financial sector (Chart II-4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart II-5). Chart II-2Brits Saw Inequality Surge Brits Saw Inequality Surge Brits Saw Inequality Surge Chart II-3Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Chart II-4The Financial Bubble Burst The Financial Bubble Burst The Financial Bubble Burst Chart II-5 The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart II-6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart II-7). Chart II-6 Chart II-7 The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart II-8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart II-9).3 Chart II-8EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 Chart II-9The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart II-10). Neither forecast was popular with our client base, but both have been spot on. Chart II-10Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart II-11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart II-11Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart II-12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart II-13). Chart II-12Bregret Has Set In... Bregret Has Set In... Bregret Has Set In... Chart II-13...And Brits Feeling More European ...And Brits Feeling More European ...And Brits Feeling More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart II-14). Chart II-14 Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram II-1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Chart II- Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart II-15). Chart II-15Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. Furthermore, polling data (presented in Chart II-12 and Chart II-13 on page 28) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart II-12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart II-16). Chart II-16Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart II-17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart II-17Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart II-18). Chart II-18A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart II-19). Chart II-19Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Marko Papic Senior Vice President Chief Geopolitical Strategist Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts Equities have had a volatile month of March, something that was bound to happen after the violent rally witnessed from the end of December to the end of February. When a rally is being tested, it always make sense to review our indicators to gauge whether or not a trend change is in the offing. Generally, our indicators remain broadly positive. Our Willingness-to-Pay (WTP) indicators for the U.S. and the euro area continue to improve. Meanwhile, it has begun to hook back up in Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) has however once again deteriorated, suggesting that the period of churn in global equities prices could last a bit longer. This indicator is essentially saying that in order to resume their ascent, stocks need a bit more time to digest their previous surge. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. According to BCA’s Composite Valuation Indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, despite this year’s rally, the S&P 500 offers a much more attractive risk/reward profile than it did in the fall. Moreover, our Monetary Indicator has shifted out of negative territory for stocks, and is now decisively in stimulative territory. The Fed’s dovish forward guidance last week only reinforces the message from this indicator. Our Composite Technical Indicator for stocks had broken down in December, but it is finally flashing a buy signal. This further confirms that the current period of churn is most likely to ultimately make way for a continued rally in the S&P 500. The 10-year Treasury yield remains within its neutral range according to our valuation model. Moreover, our technical indicator flags a similar picture. This means that without signs of improvements in global growth, price action alone will not be enough to lift bond yields higher. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth become evident, bonds could suffer a violent selloff. The U.S. dollar is still very expensive on a PPP basis. Our Composite Technical Indicator is not as overbought as it once was, but it is far from having reached oversold levels either. This combination suggests that the greenback could experience further downside this year. However, for this downside to materialize, global growth will first have to stabilize. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2       Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3       Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. 4       One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5       Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6       Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7       President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights The current trajectory in global share prices resembles what took place in 2000 and early 2001. The early 2001 rebound in global and EM stocks lasted several weeks only, despite ongoing easing by the Federal Reserve. Corporate profits – not the Fed – was the key driver in 2001 and remains the principal driver of global and EM stocks today. EM corporate profits are set to contract this year due to China’s continuing slowdown and weakening global trade. This suggests the current EM rally is unsustainable; continue underweighting EM. In Chile, bet on lower swap rates. Continue shorting the peso but overweight the local bourse within an EM equity portfolio. Feature The dovish shift by the U.S. Federal Reserve in the past month has boosted EM risk assets and currencies. Yet, we find that in the medium and long term there is a very low correlation between Fed policy and U.S. interest rates, on the one hand, and EM financial markets on the other. Instead, EM risk assets and currencies correlate with EM/China business cycles and global trade (Chart I-1). We have not detected any improvement in China/EM growth, nor in global trade (Chart I-1). What’s more, we expect Chinese growth and world trade to continue to weaken in the coming six months. Therefore, the EM rebound and outperformance will be reversed sooner than later. Chart I-1Global Growth Indicators Do No Confirm EM Rally Global Growth Indicators Do No Confirm EM Rally Global Growth Indicators Do No Confirm EM Rally Please note this is the view of BCA’s Emerging Markets Strategy team. BCA’s house view is presently positive on global risk assets and global growth. The basis for this difference between our current position and that of the majority of our colleagues is the outlook for China’s growth. A Replay Of 2016 Or 2001? Most investors are betting that 2019 will be a replay of 2016, when the Fed’s dovish turn and China’s stimulus propelled the EM and global equity rallies. It is enticing to compare the current episode in financial markets to the one that occurred only three years ago. To be sure, there are a lot of similarities: the global trade slowdown driven by China/EM, selloffs in global equity and credit markets, a dovish shift in the Fed’s stance and policy stimulus in China are all reminiscent of early 2016. Not surprisingly, this has created a stampede into EM. According to the most recent Bank of America Merrill Lynch survey, as of mid-January some 29% of investors were overweight EM stocks compared to 1% overweight in the U.S., 11% underweight in the euro area and 1% underweight in Japan. By now, the overweight in EM equities is most likely even higher, given the stampede into EM assets that has occurred over the past several weeks. This stands in contrast to the 33% underweight in EM equities in January 2016. It is apparent that the majority of investors are indeed extrapolating 2016 into 2019. We hold a different view and believe China’s slowdown will be more protracted than in 2015-’16, and that EM corporate earnings are set to contract (please refer to Chart I-5 on page 6). A key distinction between China’s current policy efforts and what was implemented in 2015-‘16 is the absence of stimulus for real estate. The odds are that China’s property market will continue to languish, weighing on household and business sentiment as well as spending. Further, the efficiency of monetary transmission mechanisms could be lower today than it was in 2016 due to the regulatory tightening on both banks and non-banks. The fiscal multiplier could also be lower due to the fragile sentiment among consumers and businesses. We discussed these issues in detail in our January 17, 2019 report. Remarkably, it appears that global share prices are tracking the pattern of 1998-2001 – their trajectories are identical in terms of both magnitude and duration (Chart I-2). Chart I-2Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration That said, there are substantial differences between today and 2001 in respect to the economic backdrops in the U.S. and China. Our focal point is to demonstrate that the Fed easing is not sufficient to prop up share prices if it does not lead to a recovery in corporate earnings. We conclude that the latest rebound in EM risk assets is probably late because neither the Fed’s pause nor China’s stimulus will revive EM corporate profits in the next nine months. In terms of market action, one can draw a number of parallels between the trajectory in global share prices today and in 2000-’01. Following an exponential rally in 1999, the global equity index peaked in January 2000 (Chart I-3). The equity selloff accelerated in the last quarter of 2000, with stocks plunging in December of that year. Chart I-3Is Rebound In Global And EM Stocks Late? Is Rebound In Global And EM Stocks Late? Is Rebound In Global And EM Stocks Late? Oversold conditions in global share prices and the Fed’s intra-meeting 50-basis-point rate cut on January 3, 2001, generated a 7% and 15% rebound in global and EM stocks, respectively. The bounce lasted from late December 2000 until early February 2001. The current trajectory in global share prices – the rollover in late January 2018, the top formation lasting several months followed by a dramatic plunge, the bottom in late December, 2018 and the subsequent rebound – closely resemble the path global share prices took in 2000 and early 2001 (Chart I-3, top panel). The same holds true for EM share prices (Chart I-3, bottom panel). Critically, the Fed continued to cut interest rates in 2001 and 2002, yet the bear market in global equities, including EM, persisted until March 2003 (Chart I-4A and I-4B, top panels). The culprit was shrinking corporate profits (Chart I-4A and Chart I-4B, bottom panels). Chart I-4AFed Easing Did Not Help Global Stocks In 2001 Fed Easing Did Not Help Global Stocks In 2001 Fed Easing Did Not Help Global Stocks In 2001 Chart I-4BFed Easing Did Not Help EM Stocks In 2001 Fed Easing Did Not Help EM Stocks In 2001 Fed Easing Did Not Help EM Stocks In 2001 Odds are that EM earnings are set to contract this year as discussed below and shown in Chart I-5. As a result, this view bolsters our conviction that EM equities are likely to roll over soon and plunge anew in absolute terms, and certainly underperform U.S. stocks. Bottom Line: There are many economic differences between today and 2001. Our main point is that the Fed easing-inspired rally in global equities in early 2001 lasted several weeks only and was followed by a new cycle low. The key factor was not Fed policy but corporate profits. Provided our view that corporate earnings in EM and global cyclical sectors will contract this year, the rally in these segments is not sustainable regardless of Fed policy. What Drives EM: Chinese Or U.S. Growth? Predicting the outlook for China and global trade correctly is key to getting the EM call right. First, China’s credit and fiscal spending impulse leads EPS growth of companies included in the EM MSCI equity index by nine months, and it currently points to continued deceleration and contraction in EM EPS in the months ahead (Chart I-5, top panel). The average of new and backlog orders within China’s manufacturing PMI also portends a negative outlook for EM corporate earnings (Chart I-5, bottom panel). Chart I-5EM Profits Are Heading Into Contraction EM Profits Are Heading Into Contraction EM Profits Are Heading Into Contraction The primary linkage between China’s credit and fiscal spending impulse and EM profits is as follows: China impacts EM and the rest of the world via its imports. This explains why EM share prices correlate with Chinese PMI imports (Chart I-6). Chart I-6Chinese Imports And EM Equities Chinese Imports And EM Equities Chinese Imports And EM Equities Second, China’s imports are to a large extent driven by capital spending, especially construction. Some 85% of mainland imports are composed of various commodities, industrial goods and materials, and autos. Consumer goods make up only about 15% of imports. Major capital expenditures in general and construction, in particular, cannot be undertaken without financing. This is why the country’s credit and fiscal spending impulse leads its imports cycles (Chart I-7). This impulse is presently foreshadowing a deepening slump in mainland imports and by extension its suppliers’ revenues and profits. Chart I-7Chinese Imports Are Heading South bca.ems_wr_2019_02_07_s1_c7 bca.ems_wr_2019_02_07_s1_c7 Third, as EM shipments to China dwindle, not only will EM corporate revenues and profits disappoint but EM currencies will also depreciate. The latter bodes ill for EM U.S. dollar and local currency bonds. The basis is that exchange rate depreciation makes U.S. dollar debt more expensive to service, and also pushes up local bond yields in high-yielding EM fixed-income markets. Fourth, The majority of developing economies sell more to China than to the U.S. Remarkably, global trade and global manufacturing decelerated in 2018, even though U.S. goods imports were booming (Chart I-8). Crucially, the more recent strength in the U.S.’s intake of goods was in part due to frontloading of shipments to the U.S. before the import tariffs went into effect on January 1, 2019. Chart I-8U.S. Imports Are Very Robust U.S. Imports Are Very Robust U.S. Imports Are Very Robust Yet despite robust U.S. demand, aggregate exports of Korea, Taiwan, and Japan have done poorly and their manufacturing have slumped (Chart I-9A and Chart I-9B). Chart I-9AAsian Exports: Flirting With Contraction Asian Exports: Flirting With Contraction Asian Exports: Flirting With Contraction Chart I-9BAsian Manufacturing: Flirting With Contraction Asian Manufacturing: Flirting With Contraction Asian Manufacturing: Flirting With Contraction This highlights the increased significance of Chinese demand and the diminished importance of U.S. domestic demand in world trade. In particular, at $6 trillion, EM aggregate goods and services imports, including Chinese imports (but excluding China’s imports for processing and re-exporting), is greater than the combined imports of the U.S. and EU, which currently stand at $4.7 trillion ($2.5 trillion plus $2.2 trillion, respectively). Finally, the media and many investors have exaggerated the impact of U.S. tariffs on the Chinese economy. We are not implying that the tariffs are not relevant at all, or that they have not damaged sentiment among mainland businesses and households. They have. The point is that China’s exports to the U.S. constitute 3.8% of Chinese GDP only (Chart I-10). This compares to Chinese capital spending amounting to 42% of GDP and total annual credit origination and fiscal spending of 26% of GDP. Chart I-10China's Exports To U.S. Are Small (3.8% of GDP) China's Exports To U.S. Are Small (3.8% of GDP) China's Exports To U.S. Are Small (3.8% of GDP) Overall, China’s growth slowdown in 2018 was not due to its plunging shipments to the U.S. – actually, the latter were rising strongly till December due to frontloading – but due to weakness in credit origination, primarily among non-banks (shadow banking). Bottom Line: The Chinese business cycle – not the U.S.’s – is the key driver of EM share prices and currencies and more important than the Fed. EM And The Fed On the surface, it seems that EM is tracking Fed policy. To us, however, this is akin to“not seeing the forest for the trees”. Investors need to stand back and examine the medium- and long-term relationships between U.S. interest rates, DM central banks’ balance sheets, and EM financial markets. In this broader context, the following becomes apparent: There is no stable correlation between EM share prices, EM currencies and EM sovereign credit, on the one hand, and U.S. 10-year bond yields, on the other (Chart I-11). Chart I-11EM And U.S. Bond Yields: No Stable Correlation EM And U.S. Bond Yields: No Stable Correlation EM And U.S. Bond Yields: No Stable Correlation Historically, the correlation between EM share prices and the Fed funds rate has been mixed, albeit more positive than negative (Chart I-12). On this 40-year chart, we shaded the periods when EM stocks did well during periods of a rising fed funds rate. These time spans are 1983-1984, 1988-1989, 1999-2000, 2003-2007 and 2017. Chart I-12EM Stocks And Fed Funds Rate: A Historical Perspective EM Stocks And Fed Funds Rate: A Historical Perspective EM Stocks And Fed Funds Rate: A Historical Perspective The only two episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican peso crisis. Yet, it is essential to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Remarkably, there is also no correlation between the size and the rate of change of DM central banks’ balance sheets, on the one hand, and EM risk assets and currencies on the other. In particular, Chart I-13 validates that the annual growth rate of G4 central banks’ balance sheets does not correlate with either EM share prices or EM local currency bonds’ total returns in U.S. dollars. Chart I-13Pace Of QEs And EM: No Correlation Pace Of QEs And EM: No Correlation Pace Of QEs And EM: No Correlation Finally, there is a low correlation between U.S. real interest rates and the real broad trade-weighted dollar (Chart I-14). Notably, Chart I-15 illustrates that the greenback often acts as a countercyclical currency, appreciating when global growth is slowing and depreciating when the global business cycle accelerating. Please note that the dollar is shown inverted on this chart. Chart I-14The U.S. Dollar And U.S. Real Rates The U.S. Dollar And U.S. Real Rates The U.S. Dollar And U.S. Real Rates Chart I-15The U.S. Dollar Is Countercyclical The U.S. Dollar Is Countercyclical The U.S. Dollar Is Countercyclical Bottom Line: Many analysts and investors assign more significance to the Fed policy’s impact on EM risk assets than historical evidence warrants. Unless Fed policy easing coincides with EM growth recovery, the Fed’s positive impact on EM will prove to be fleeting. Investment Considerations Widespread bullish bias on EM among investors currently and a continuous slew of poor growth data in China and global trade give us the conviction to argue that the current EM rally is not sustainable. Even if the S&P 500 drifts higher, EM stocks and credit will underperform their U.S. counterparts (Chart I-16). Chart I-16Stay Short EM / Long S&P 500 Stay Short EM / Long S&P 500 Stay Short EM / Long S&P 500 The EM equity index is sitting at a major technical resistance, and a decisive break above this level will challenge our view (Chart I-17, top panel). The same holds true for many EM currencies and copper (Chart I-17, bottom panel). However, for now, we are maintaining our negative bias. Chart I-17EM Equities And Copper Are Facing Resistance EM Equities And Copper Are Facing Resistance EM Equities And Copper Are Facing Resistance Within the EM equity universe, our overweights are Brazil, Mexico, Chile, Russia, central Europe, Korea, and Thailand. Our underweights are Indonesia, India, Philippines, South Africa, and Peru. We continue to recommend shorting the following EM currency basket versus the U.S. dollar: ZAR, IDR, MYR, CLP, and KRW. The full list of our recommended positions across EM equities, local rates, credit, and currencies is available on pages 17-18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). Chart II-1Chile: Favor Bonds Over Stocks Chile: Favor Bonds Over Stocks Chile: Favor Bonds Over Stocks The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. Chart II-2Chile: Labor Force Is Expanding At 2% Chile: Labor Force Is Expanding At 2% Chile: Labor Force Is Expanding At 2% The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-3Chile: Wage Growth Is Decelerating Chile: Wage Growth Is Decelerating Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices.  There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Chart II-4Chile: Inflation Is Within Target Range Chile: Inflation Is Within Target Range Chile: Inflation Is Within Target Range Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-5Chilean Exports Are About To Contract Chilean Exports Are About To Contract Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade. Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2018. We will resume our regular publishing schedule on January 2, 2019 with a Special Report on urbanization/industrialization. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports   The evidence over the past year raises the odds that China’s economy has entered a multi-year period of frequent mini-cycles. A mini-cycle world would be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. There is no magic wand to quickly transform China into a services-oriented economy, and it is not clear that the gains in tertiary sector GDP since 2010 are sustainable. A slow transition would raise deep questions about China’s growth model over the coming 2-3 years, and would create a major dilemma for policymakers. Chinese stocks are considerably cheaper than they were a year ago, yet they may be cheap for a reason (even over the very long term). On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral barring even lower prices or tangible evidence of successful structural reforms. Feature Following the publication of our special year end Outlook report for 2019,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. Mini-Cycles, And The Policy Trade-Off Between Growth And Leveraging Over the past year we have described the progression of Chinese growth as part of an economic “mini-cycle”, one that actually began in early-2014 (we have focused on the expansion period of the cycle that started in mid-2015). While this is the first clear mini-cycle in China after a prolonged period of slowing activity that followed the enormous stimulus of 2008/2009, many investors and market participants have speculated about whether these types of events will become more prevalent in the future. In a March 2017 BCA Special Report,3 my colleague Arthur Budaghyan speculated about the potential for such cycles within the context of a falling primary growth trend. Arthur’s argument was that cyclical growth could hold up in China over the coming few years only if the government allows credit growth to continue booming, but that this would entail creeping socialism/statism that would cripple the country’s productivity and thus its potential growth. In fact, the experience of the past three years suggests that mini-cycles may occur over the coming few years even if policymakers do try to prevent a falling primary growth trend. Chart 1 shows that the slowdown in domestic demand that investors only began to price in the middle of this year has clearly been caused by a slowing in money & credit growth (as represented by our leading indicator), which in turn strongly appears to have occurred because of monetary tightening that began at the end of 2016 (panel 2). This tightening has been closely linked to the government’s attempt to de-risk the financial sector. Chart 1Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown In addition, we presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds (Chart 2), underscoring that Chinese authorities now face a policy trade-off between growth and leveraging.4 The inference is that investors can expect more of these episodes so long as policymakers stay committed to reforming the financial sector, a policy that appears to remain a strong priority of the Xi government. Chart 2SOEs Now Have A Negative Net Return On Borrowed Funds SOEs Now Have A Negative Net Return On Borrowed Funds SOEs Now Have A Negative Net Return On Borrowed Funds Chart 3 presents three stylized scenarios as a possible multi-year roadmap for investors faced with a “mini-cycle world”. Scenario 1 represents the pessimistic case articulated by Arthur, a set of frequent cycles occurring against the backdrop of a falling primary (or potential growth) trend. Scenarios 2 and 3 represent possible outcomes emerging from successful structural reform: in scenario 2 the downtrend in potential growth is arrested and the primary growth trend becomes flat, whereas scenario 3 depicts the optimistic case, where reform initiatives unleash productivity gains that result in a net increase in potential growth. In both scenarios 2 and 3, the frequency of economic cycles is reduced to be more akin to that of typical business cycles in the developed world, ending the more rapid mini-cycle phase that preceded the success of the reforms. Chart 3A Potential Roadmap For Investors Living In A "Mini-Cycle World" A Potential Roadmap For Investors Living In A "Mini-Cycle World" A Potential Roadmap For Investors Living In A "Mini-Cycle World" For an investor primarily concerned with cyclical asset allocation, one response to Chart 3 might be that any of the scenarios are acceptable because there is money to be made in each case by shifting one’s investment stance in advance of key inflection points. However, as Arthur alluded to in last year’s report, the cycles depicted in Chart 3 are highly stylized and will not repeat themselves over regular, predictable intervals. In addition, even in scenarios 2 and 3, the higher frequency of oscillations depicted in the chart prior to the positive impact of structural reforms means that a mini-cycle world will be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. From a longer-term perspective, Chart 3 clearly outlines two key questions that investors should be asking themselves about China if we truly have entered a multi-year period of frequent mini-cycles: Is there tangible evidence of a falling primary growth trend in China, and can this be detected ex-ante rather than ex-post? What are the markers for successful structural reform, and how can progress be tracked in real-time? These are of course difficult questions to answer, and our thoughts are likely to evolve as more evidence presents itself. However, for now, we note the following: Chart 4 presents some evidence of declining potential growth in China, or more precisely a decline in the natural rate of interest. The chart shows that the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China’s economy. Chart 4There Is Some Evidence That China's Natural Rate Of Interest Has Declined There Is Some Evidence That China's Natural Rate Of Interest Has Declined There Is Some Evidence That China's Natural Rate Of Interest Has Declined We also presented some evidence in our November 21 Weekly Report showing that China’s monetary policy transmission mechanism is impaired.5 Chart 5 shows that the recent decline in interbank repo rates implies that average lending rates are set to decline materially over the coming months; measuring the strength of the reaction in the old economy to this decline will provide investors with another crucial observation about the responsiveness of the economy to interest rates. Chart 5More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge Concerning potential signposts of successful structural reform, signs that the government is about to undertake a big-bang cleanup and reorganization of China’s SOEs, one that involves the large-scale transfer of bad SOE debts to the public sector, would obviously be the primary event for investors to watch for. We assume that this will not occur over the coming few years barring a major crisis. At the firm level, non-trivial deleveraging, privatization/incorporation, material capital injection/withdrawal, material divestment of non-core fixed assets and (to a lesser degree) reduction in the wage bill relative to the industry have all shown themselves to be significantly related to the odds of a “zombie” firm returning to a healthy financial state.6 Even quiet signs that SOEs may be going through this process would be a positive indication of the potential for reform. At the macro level, our signposts of successful structural reform would be indications that SOE return on assets is set to rise back above borrowing costs (because of a material rise in the former, not a significant decline in the latter), tangible evidence of passive deleveraging (debt to nominal GDP falling because of a sustained rise in the latter), and a structural rise in the presence of private firms in China’s economy. Chart 6 shows that, at least in the case of the latter, progress appears elusive. Chart 6The Size Of The Private Sector In China Is Now Moving In The Wrong Direction The Size Of The Private Sector In China Is Now Moving In The Wrong Direction The Size Of The Private Sector In China Is Now Moving In The Wrong Direction Over the shorter-term, global investors are strongly focused on whether we are about to enter another mini-cycle upswing, a view that we have recently argued against. We presented our base case view for 2019 in our December 5 Weekly Report2, which is that growth will modestly firm in the second half of 2019 and will provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. But we underscore that the character of the improvement is likely to be materially different than what occurred in 2016, implying that investors betting on substantial returns from China-related financial assets next year are likely to be disappointed. Transitioning To A Services-Oriented Economy: There Is No Magic Wand Part of the structural reform agenda articulated by Xi Jinping involves transitioning China's economy towards the tertiary sector (services). Services activity, in general, tends to have higher added value than manufacturing, construction, and raw material extraction, and it is hoped that a more services-oriented economy will increase China’s per capita GDP and help the country escape the middle-income trap. Chinese policymakers have been very clear about their intention to promote this shift and have emphasized their need to do so quickly, but have not been very clear about how they plan to do so. Admittedly, there is some evidence to suggest that this trend has already begun: Chart 7 shows that tertiary industry GDP has risen as a share of overall GDP by about 7.5 percentage points since 2010, tertiary industry electricity consumption as a share of total is rising steadily, and the market capitalization of information and communication technology-related sectors has risen in China’s domestic and investable equity market (sharply in the case of the latter).7 Chart 7Some Signs Of A Move Towards Services... Some Signs Of A Move Towards Services... Some Signs Of A Move Towards Services... However, BCA’s China Investment Strategy service has been and remains quite skeptical about the likely pace of this transition, which raises deep questions about China’s growth model over the coming 2-3 years: Chart 8 breaks down the increase in tertiary industry GDP as a share of total from 2010 – 2017 into individual sectors.8 The chart shows that finance-related sectors (financial intermediation, leasing & business services, and real estate) accounted for nearly half of the increase in services GDP over the period. It seems difficult to expect that this trend will continue in an environment where the government is trying to contain financial sector risk. Chart 8 Chart 8 shows that tech-related sectors accounted for the second largest increase in tertiary industry GDP over the period, which is not surprising given the data shown in panel 3 of Chart 7. However, there are three problems with assuming that China’s tech sector will expand at a very rapid pace from current levels. First, Chart 9 makes it clear that the incubation period for China’s largest two technology companies by market capitalization was quite long. Alibaba and Tencent were both formed nearly 20 years ago, and only recently gained significant traction. Second, neither of these firms appears to have succeeded because of Chinese industrial policy, underscoring the importance of dynamic, competitive, private markets in driving innovation. Third, other successful examples of “breakthrough” state support for industries show that the process is not a rapid one. In the U.S. between 1978 and 1992, the U.S. Department of Energy invested in the Eastern Gas Shale Program, which contributed somewhat to the development of fracking technology used in shale oil & gas production today. Chart 10 shows how long it took for this program to bear fruit: gas production began to trend higher 12 years after the end of the program, whereas it took nearly two decades for oil production to begin to move higher. And even in this case, the role of private industry in commercializing the technology was overwhelmingly dominant. Chart 9The Incubation Period Of China's Major Tech Success Stories Was Quite Long The Incubation Period Of China's Major Tech Success Stories Was Quite Long The Incubation Period Of China's Major Tech Success Stories Was Quite Long Chart 10The Dividends From State-Assisted R&D Can Take A Long Time To Occur The Dividends From State-Assisted R&D Can Take A Long Time To Occur The Dividends From State-Assisted R&D Can Take A Long Time To Occur It is encouraging to see that education spending in China has increased as a share of GDP over the past several years, as services activity typically requires a highly educated workforce as an input. But China’s post-secondary educational attainment (defined here as the share of 25-34 year olds with tertiary education) appears to be too low to make a meaningful leap over the next 2-3 years (Chart 11). We acknowledge that China’s educational achievement ranks quite highly relative to the world, and this speaks to the high quality of skilled labor in China. However, for now, China’s attainment rate appears to be too low for the country to rapidly shift to services. Chart 11 Finally, Chart 12 shows that while tertiary industry electricity consumption is rising as a share of total, it remains small compared with secondary industry consumption. This underscores that China’s shift to a truly-services oriented economy is something that will take a considerable amount of time. What does a slow transition from secondary to tertiary industry mean for investors? To us, it either raises the risk that: Chart 12A Long Way To Go A Long Way To Go A Long Way To Go policymakers will have to rely on China’s old growth model for longer than they intend, or that Chinese growth will slow considerably more over the coming few years than investors currently expect. In the first case, policymakers may be on a collision course with the reality of poor financial health among SOEs, which as we noted earlier already have a negative net return from leveraging. In the second case, the threat is clear: China’s contribution to global growth could decline sharply, with potentially severe consequences for China-related financial assets. Cheap(er) Chinese Stocks: A Great Long-Term Buying Opportunity? We have received several questions from clients over the past few months asking whether they have been presented with a great long-term buying opportunity for Chinese stocks, even if cyclical economic conditions are set to weaken from current levels. Chart 13In The U.S., Valuation Predicts Long-Term Returns Quite Successfully In The U.S., Valuation Predicts Long-Term Returns Quite Successfully In The U.S., Valuation Predicts Long-Term Returns Quite Successfully This is a valid line of inquiry. Over a 6-12 month time horizon, valuation rarely drives asset returns, and we recently argued against the view that valuation could act as an overwhelming rally catalyst for Chinese stocks in 2019. However, we agree that valuation should be increasingly considered as one’s time horizon expands. Chart 13 shows that valuation has been a powerful predictor of 10-year future performance for the U.S. equity market, and Chart 14 shows that the forward P/E ratio for both domestic and investable Chinese stocks has certainly improved over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been, but haven’t usually been cheaper (at least over the past decade). This is particularly true for the A-share market (Chart 15). Chart 14Chinese Stocks Are Now Considerably Cheaper Than A Year Ago... Chinese Stocks Are Now Considerably Cheaper Than A Year Ago... Chinese Stocks Are Now Considerably Cheaper Than A Year Ago... Chart 15...Although They Have Been Cheaper In Relative Terms ...Although They Have Been Cheaper In Relative Terms ...Although They Have Been Cheaper In Relative Terms We struggle to answer the question, because while valuation usually predicts future returns quite well, deviations from this relationship can exist. Chart 13 shows that material differences between the actual and predicted 10-year returns existed during the 1970s/early-1980s and as well during the late-1990s, and would have as well in 2008/2009 had the valuation extremes of the late-1990s not lined up so well with the timing of the global financial crisis a decade later. In short, cheap stocks can be cheap for a reason, and the structural issues that we noted above certainly highlight the potential for the next 10-years of Chinese equity market performance to be anomalous relative to what would normally be implied by current valuation. For now, the best answer we can provide is that Chinese stocks are a great long-term buy for investors who do not share our structural concerns. On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. But we will be watching closely over the coming few years for signs of successful structural reform as detailed above, and we are likely to upgrade our structural recommendation on any material progress, particularly if that progress involves a cyclical deterioration in the economy that further cheapens equities. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see The Bank Credit Analyst “OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report “The Great Debate: Does China Have Too Much Debt Or Too Much Savings? ”, dated March 23, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. 6 IMF Working Paper WP/17/266 “Resolving China’s Zombies: Tackling Debt and Raising Productivity” 7 Note that we have included the consumer discretionary sector in Chart 8 owing to the recent GICS sector changes that have included e-commerce providers such as Alibaba in the discretionary sector. 8 Note that 2016 is the most recent data point for healthcare & social security, education, scientific research & technology services, public management & social organizations, and miscellaneous others. However, their change from 2010 – 2017 reflects almost all of the change in the sum of these categories from 2010 – 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights Our take on the key macro drivers of financial markets hasn’t evolved much since we laid it out this summer, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... but the inflection points are getting nearer: The good times won’t last forever, though. The Fed is resolutely tightening policy, BBB-heavy investment-grade issuance has the corporate bond market flirting with a plague of fallen angels, and the global economy is slowing. Our strategy remains more cautious than our outlook for now, … : Although we think the equity bull market has another year to run, and the expansion will stretch into 2020, we are only equal-weight equities, while underweighting bonds and overweighting cash. … but we’re alert to opportunities to get more aggressive: Investment-grade and high-yield bonds are unlikely to offer an attractive risk-reward profile, but the S&P 500 shouldn’t decline much more if the economy holds up. Feature Mr. and Ms. X’s annual visit is an occasion for every BCA service to look toward the coming year, mindful of how it could improve on the one just past. The theme we settled on in last year’s discussion, Policy and Markets on a Collision Course, began asserting itself in earnest in October, and appears as it will be with us throughout 2019. The Fed is nearing its fourth rate hike this year, on the heels of three in 2017, and markets are warily contemplating the tipping point at which higher interest rates begin to interfere with activity. The yield curve has become a constant worry (Chart 1), with short rates moving in step with the fed funds rate while yields at the long end have been just one-half as sensitive (Chart 2). Chart 1Yield Curve Anxiety Has Exploded ... Yield Curve Anxiety Has Exploded ... Yield Curve Anxiety Has Exploded ...   Chart 2... As The Curve Has Steadily Flattened 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? Trade tensions are an even thornier policy challenge. After flitting on and off investors’ radar earlier in the year, trade barriers have been a major source of angst in recent months as central banks, investor polls and company managements increasingly cite them among their foremost concerns. Unfortunately, our geopolitical strategists do not expect relief any time soon. They see trade as just one aspect of an extended contest for supremacy between China and the U.S. Late-Cycle Turbulence, our 2019 house theme, pairs nicely with Policy-Market Collision. The gap between our terminal fed funds rate expectation and the money market’s is huge, and leaves ample room for a repricing of the entire yield curve. Trade has been a roller coaster, capable of inducing whiplash in 140 characters or less, and it may already have brought global manufacturing to the brink of a recession. Oil lost 30% in two months at the stroke of a pen; its immediate fate is in the hands of OPEC, but the caprice with which Iranian sanctions may or may not be re-imposed is likely to feed uncertainty. As we advised Mr. and Ms. X a few weeks ago, investors should stay nimble; there is no point to committing to a twelve-month strategy right now.1 The Fed Funds Rate Cycle Our equilibrium fed funds rate model estimates that the equilibrium fed funds rate, the rate that neither encourages nor discourages economic activity, is currently around 3%. It projects that the equilibrium rate will approach 3¼% by the middle of 2019, and 3⅜% by year end. The implication is that policy is comfortably accommodative now, and will not cross into restrictive territory for another 12 months – assuming that the Fed hikes four times next year, in line with our ambitious expectation. If the Fed steps back from its gradual pace, and only hikes three times in 2019 (as per the dots), or just once (as per the money market), the day when the economy and markets will have to confront tight monetary conditions will be pushed even further into the future. Stretching monetary accommodation until late next year would seem to forestall the arrival of the next recession until at least the first half of 2020. Tight policy is a necessary, if not sufficient, condition for a recession, as recessions have only occurred when the policy rate has exceeded our estimate of equilibrium over the six decades covered by our model. A longer stretch of accommodation would also continue to nourish the equity bull market and discourage allocations to Treasuries. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 1), while Treasuries have wilted, especially in the current phase of the fed funds rate cycle (Table 2). Table 1Equities Flourish When Policy’s Easy ... 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last?   Table 2... While Treasuries Stumble 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? The Business Cycle The state of policy is one of the three components in our simple recession indicator. Neither of the other two is sounding the alarm, either. Our preferred 3-month-to-10-year segment of the Treasury yield curve is still comfortably upward sloping, even if it has been steadily flattening and we expect it to invert late next year (Chart 3). Year-over-year growth in leading economic indicators decelerated slightly last month, but remains well above the zero line that has reliably preceded past recessions. Chart 3Flattening, But Not Yet Flat Flattening, But Not Yet Flat Flattening, But Not Yet Flat The Credit Cycle Anyone following the credit cycle would do well to start with the axiom that bad loans are made in good times. Its converse is just as true: good loans are made in bad times. Loan officers are every bit as susceptible to the recency bias as other human beings, and they tend to extrapolate from the freshest observations when assessing a borrower’s prospects. When things are good, lenders assume they will continue to be good, and let their guard down by lending to marginal borrowers and/or relaxing the terms on which they will lend. When things are bad, on the other hand, loans have to be underwritten so tightly that they squeak. The upshot is that lending standards and loan performance are tightly bound up with one another. In the near term, standards and performance are joined at the hip; over a five-year period, standards lead performance as a contrary indicator. Defaults almost certainly bottomed for the cycle in 2014, to judge by speculative-grade bonds (Chart 4, top panel), and loans (Chart 4, bottom panel). Standards reliably followed, and the proportion of lenders easing standards for corporate borrowers, as per the Fed’s senior loan officer survey, spiked (Chart 5). Chart 4Weakening, But Not Yet Weak Weakening, But Not Yet Weak Weakening, But Not Yet Weak   Chart 5Standards Follow Performance In Real Time ... Standards Follow Performance In Real Time ... Standards Follow Performance In Real Time ... The 2012 and 2014 peaks in willingness suggest that performance is due to erode (Chart 6). We do not foresee a step-function move higher in defaults, or a sudden collapse in loan availability, but we do expect some fraying at the edges. Given how tight spreads remain, any weakness at the margin could go a long way to wiping out much, if not all, of spread product’s excess return. The bottom line is that the credit cycle is well advanced, and investors should expect borrower performance and lender willingness to weaken from their current levels. Chart 6... And Lead Them Over The Intermediate Term ... And Lead Them Over The Intermediate Term ... And Lead Them Over The Intermediate Term Bonds We have written at length on our bearish view on rates and Treasuries.2 The key pillar supporting our rationale is the gap between our terminal fed funds rate estimate, 3.5-4%, and the market’s view that the Fed will not go beyond 2.75%, if indeed it gets to that level at all (Chart 7). The gap is big enough to drive a truck through, and leaves a lot of room for yields to shift higher all along the curve, even if the Fed were to slow its 25-bps-a-quarter tempo, as the Wall Street Journal suggested it might in a report last Thursday. We continue to believe that inflation is the inevitable outcome once surging aggregate demand collides with limited spare capacity, and that the Fed will be forced to push the fed funds rate to 3.5% and beyond. Chart 7Something's Gotta Give Something's Gotta Give Something's Gotta Give Our view that the credit cycle has already passed its peak drives our view on spread product. Though we remain constructive on the economy and the outlook for corporate earnings, we are not enamored of the risk-reward offered by corporate bonds. Although high-yield spreads blew out by nearly 125 bps from early October to late November, high yield still does not look cheap (Chart 8, bottom panel). The same holds for investment-grade spreads, which remain near the bottom of their long-term range despite widening by over 50 bps (Chart 8, top panel). Chart 8Spreads Are Still Tight Spreads Are Still Tight Spreads Are Still Tight Bottom Line: We recommend that investors underweight fixed income within balanced portfolios, while underweighting Treasuries and maintaining below-benchmark duration. We recommend benchmark holdings in spread product, but we expect to downgrade it to underweight before the end of the first half. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive for another twelve months or so, the bull market should have about another year to go. We downgraded equities to equal weight as a firm in mid-June nonetheless, on signs of global deceleration and the potentially malign effects of tariffs and other impediments to global trade. U.S. Investment Strategy fully supported that decision, but we are alert to opportunities to upgrade equities to overweight within U.S. portfolios if prices decline enough to make the prospect of a new cycle high attractive on a risk-reward basis. The risk-reward requirement implies that the fall in price would have to occur without a material weakening of the fundamental backdrop. For now, we think the fundamental supports remain stable, as per the equity downgrade checklist we constructed to keep tabs on them. The checklist monitors recession indicators, none of which betray any concern now; factors that may weigh on corporate earnings; inflation measures, because higher inflation could motivate the Fed to hike more quickly than planned, with adverse consequences for the bull market; and signs of overexuberance (Table 3). Table 3Equity Downgrade Checklist 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? The earnings-pressure section focuses on the key factors that might signal margin contraction – wage growth, dollar strength and rising bond yields – but none of them look especially problematic now. While we think compensation gains will eventually push the Fed to go beyond its own terminal rate estimates, they have not yet picked up enough to cause concern. The dollar has paused in its advance, mostly marking time since the end of October. Only BBB corporate yields have gotten closer to checking the box (Chart 9). BCA’s preferred margin proxies remain in good shape, on balance (Chart 10), and our EPS profit model is calling for robust profit growth across all of next year (Chart 11). Chart 9Higher Rates Will Exert Some Margin Pressure Higher Rates Will Exert Some Margin Pressure Higher Rates Will Exert Some Margin Pressure   Chart 10In The Absence Of Margin Pressures, ... In The Absence Of Margin Pressures, ... In The Absence Of Margin Pressures, ...   Chart 11... 2019 Earnings Could Hold Up Nicely ... 2019 Earnings Could Hold Up Nicely ... 2019 Earnings Could Hold Up Nicely Oil’s plunge has pulled both headline CPI and longer-run inflation expectations lower. Although we think that the inflation respite is merely a head fake, and that oil will soon regain its footing (please see below), the run of harmless inflation data has the potential to soothe some market concerns about the Fed. If the Fed itself takes the data at face value, it may signal that the current 25-bps-a-quarter gradual pace could be slowed. As for exuberance, the de-rating the S&P 500 has endured since its forward multiple peaked at 18.5 in January suggests that it’s not a problem. We are not living through anything remotely resembling an equity mania. Bottom Line: BCA’s mid-June downgrade of global equities from overweight to equal-weight was timely. We remain equal-weight in balanced U.S. portfolios, but are more likely to upgrade U.S. equities than downgrade them, given the supportive cyclical backdrop. Oil We devoted our report two weeks ago to the oil outlook and its implications for the economy. Our Commodity & Energy Strategy service’s bullish 2019 view has not changed: it still sees a market in a tight supply/demand balance with high potential for supply disruptions and a smaller-than-usual inventory reserve to make up the slack. The unexpected release of over a million barrels a day of Iranian output has played havoc with oil prices, but does not provoke the growth concerns that declining demand would. Provided OPEC is able to agree on production cuts, and abide by them going forward, our strategists see Brent and WTI averaging $82 and $76/barrel across 2019. The Dollar We remain bullish on the dollar, though it will find the going rougher than it did in 2018. Traders have built up sizable net long positions, so it will take more for the greenback to extend its advance than it did to begin it. Ultimately, we think desynchronization between the U.S. and the rest of the major DM economies will keep the dollar moving higher. If the U.S. does not continue to outgrow the currency-major economies by a healthy margin, and/or the Fed does not respond to that growth by hiking rates to prevent overheating, the dollar’s advance may be nearly played out. Putting It All Together Three major assumptions underpin our views: The U.S. economy is at risk of overheating in its second year of markedly above-trend growth fueled by fiscal stimulus, and the Fed will respond to that risk by decisively raising rates. There will be a noticeable global slowdown, but it will not go far enough to turn into a recession. The U.S. will remain mostly immune to the global slump. We will be positioned well if all of these assumptions are validated by events, though timing is always uncertain. Financial-market volatility often increases late in the cycle, and we expect the backdrop to remain fluid. We are trying to maintain a fluid mindset in kind, monitoring the incoming data to make sure our cyclical assessments still apply, while remaining alert to opportunities created by significant price swings. Although we are neither traders nor tacticians, we want to retain some flexibility, and are trying to resist mentally locking in our positioning for the entire year. We are particularly focused on the monetary policy backdrop and the transition from accommodative to restrictive policy, which has historically been critically important for asset allocation. Our main goal is to anticipate the approach of inflection points in the key cycles – business, credit and monetary – as adeptly as we can. We are also resolved to look through the noise of one-off price swings and the blather that has already been clogging the airwaves. We seek to help our clients formulate a strategy for navigating the turbulence without being swept up in it. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the December 2018 Bank Credit Analyst, “Outlook 2019: Late-Cycle Turbulence,” available at www.bcaresearch.com. 2 Please see the July 30, 2018 U.S. Investment Strategy, “The Rates Outlook,” the September 17, 2018; U.S. Investment Strategy, “What Would It Take To Change Our Bearish Rates View?” and the November 5, 2018; U.S. Investment Strategy, “Checking In On Our Rates View,” available at usis.bcaresearch.com.

Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation 1. EM Equity Prices And Fed Funds Rate: Mixed Correlation 1. EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Asian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. EM: Stay Put EM: Stay Put Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Manufacturing Is Slowing In China And EM ex-China Manufacturing Is Slowing In China And EM ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating bca.ems_wr_2018_09_06_s1_c5 bca.ems_wr_2018_09_06_s1_c5 Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China bca.ems_wr_2018_09_06_s1_c6 bca.ems_wr_2018_09_06_s1_c6 Chart 7Semiconductor Prices Are Plunging Semiconductor Prices Are Plunging Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Asian Export To Slow Further Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising EM: Interbank Rates Are Rising EM: Interbank Rates Are Rising Chart 9BEM: Interbank Rates##br## Are Rising EM: Interbank Rates Are Rising EM: Interbank Rates Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth EM: Local Currency Bonds Yields And Narrow Money Growth EM: Local Currency Bonds Yields And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations